The Lender Decision Tree and Limited Resale Inventory

Borrowers are done paying, and their hanging up on lenders. The lenders are still hesitating, waiting for borrowers to pay. Lenders will wake up one day and start the foreclosure process in earnest. Will it be too late?

The Lender Decision Tree

When lenders make loans, they far prefer borrowers to repay those loans; in fact, their entire business plan relies on it. As long as borrowers are current with their payments, lenders are happy and making money. When borrowers don’t make their payments, the end result is a distressed sale. If there are enough of these, market prices are reduced dramatically which causes significant lender losses.

Below is the lender decision tree for delinquent borrowers. Today we will explore this diagram in some detail and discuss the ramifications of the decisions lenders make.



Loan Modifications

Once a borrower stops paying on the loan, the first step in the process is to attempt a loan modification. Many borrowers are using this step as a place to game the system for more time in the property. If the loan modification is successful, then the borrower is made current and everyone is happy. Very few loan modfications are successful mostly because it isn’t in a borrower’s best financial interest to get temporary relief and sustain the huge debt. Loan modifications are the first step in the amend-pretend-extend dance.

Short Sale

The next option is a short sale. This process generally goes nowhere because Banks Refuse to Recognize HELOC and Second Mortgage Losses. To give a sense of scale of this problem, consider this: “Together with Citigroup the banks hold about 42 percent of the $1.1 trillion in second-home liens. Unlike first mortgages, they are typically not bundled and sold off to investors but kept on the banks’ books. The biggest home-equity lender in the U.S. is Bank of America, holding some $138 billion in such loans. Wells Fargo has about $123.8 billion of home-equity loans.” These loans are all going to go bad, and it will decimate the banking industry when these losses are finally recognized.

Short sales are not going to be the final resolution of this problem for one main reason: many distressed sellers do not bother to attempt a short sale. First, for those with non-recourse loans, they are foolish to attempt a short sale because buried in the terms of the sale is the abandonment of their non-recourse status. Plus, why would they go through the hassle? The magnitude of the loss doesn’t impact the borrower, so there is little incentive for them to participate in the short sale process. Once they decide they are not going to sell and obtain any equity, most people stop paying and stop responding to lender inquiries. If borrowers don’t care enough about the property to communicate with the bank, they certainly are not going to get involved in a short sale process.

If a short sale does go through, it is still a distressed sale. It is a sale that probably would not be occurring in the market if the borrower were not in distress. These should be inventory added to the organic inventory of people moving for other reasons. One of the side effects of having 11.2 million properties underwater is that about 25% of our organic sales inventory is removed from the market. People are trapped in their homes.

Squatting and shadow inventory

Once loan modifications and short sales have failed, the only options available to lenders are within the foreclosure process. At this point, borrowers are not making payments, and contractually, lenders have the right to force the sale of the property at public auction. Prior to the Great Housing Bubble, it was inconceivable that lenders would allow borrowers to squat in houses once it became obvious they were not going to repay the loan. Now that over 10% of loans in the United States are delinquent, lender are overwhelmed by the volume. And since lenders know that foreclosing on all those people will cause them catastrophic losses on their second-home lien portfolios in addition to crushing home prices, they are choosing not to do anything. More than one-third of all delinquent borrowers have been delinquent for more than a year. Squatters are everywhere.

The reason lenders are allowing widespread squatting are twofold:

  1. Lenders hope that people in this category will cure their loans with a loan modification. Nobody believes this is the cure to the problem, not even the lenders.
  2. The government benefits by having fewer homeless and no rioting in the streets. The twenty-first century’s version of squatter’s rights is allowing delinquent homeowners to stay in their homes. It prevents Hoovervilles and provides significant economic stimulus through the temporary elimination of housing expenses. Too bad it totally screws renters who don’t enjoy such benefits.

Shadow inventory is foreclosure’s purgatory. It prepares delinquent borrowers for the singularity of trustee sale.

Pre-Foreclosure Inventory

Once lenders finally serve notice on the squatters, these properties show up as pre-foreclosure inventory and we can see them on Although the amend-pretend-extend dance is primarily keeping people in shadow inventory, a huge number of properties are bottlenecking in pre-foreclosure.

We have been watching the foreclosure market very closely. Ordinarily, very little inventory exists here because once the process is started, it tends to move forward in an orderly process and is resolved in about five months. Not anymore.


I took a survey of properties scheduled for sale during the first four months of 2010. The dancing is evident. Over 50% of scheduled trustee sales are postponed, some of them are postponed many times. Over 25% are cancelled, presumably due to a loan modification. This is the outcome lenders are dancing to obtain. Less than 25% go to auction on any given day with lenders taking 10% to 15% and third parties getting 5% to 10%. It is the postponements that are most telling.

An IHB reader has contacted me about a property that has been scheduled for trustee sale for over six months. Every two weeks, the sale is postponed for another two weeks. The first mortgage on this property has not been paid since 2008, and the borrower is making no effort to pay. The one and only reason for this postponement is because the lender is unwilling to take the loss. This is happening all over, and the postponement numbers above are testament to this phenomenon.

Unfortunately, due to the endless postponements, we have been unable to put any owner-occupants into any foreclosure properties. For any given property, there is a 93% chance that the auction will be postponed, canceled, or sold back to the bank. This makes a nearly impossible environment to work with families. We will let everyone know when this changes, but for now, that is what we are up against in the foreclosure market. The dance goes on for the sake of those cancellations as lenders hope those loan modifications are successful. Most end up re-defaulting and accumulate in shadow inventory or back here on the path to foreclosure.

Keep in mind that these pre-foreclosure inventory numbers are the visible inventory. Shadow inventory is four times as large.

Limited Inventory

On any given day, less than 25% is released to the public. The effect is to restrict local inventories and cause competition among would-be buyers. Ask anyone active in the market today, and they will tell you that the competition is fierce because so little of the MLS inventory can actually transact. The few reasonably priced properties usually offered by lender REO departments get much attention. Buyers often have to bid over ask and accept onerous terms. Many sellers offer at WTF prices nobody can afford, so they are effectively out of the market. Many properties are short sales that linger for months with twenty offers waiting for the second lien holder to accept a loss. When it doesn’t happen, the property heads to foreclosure.

The effect of these conditions is to create limited inventory for the lenders to sell their own properties at inflated prices. If inventory is restricted enough, lenders capture the most motivated buyers. That is the way monopolies, oligopolies and cartels operate. Unfortunately, since this is a cartel, and since there is a huge shadow inventory, each cartel member gains advantage over the others by releasing more inventory. Once the administrative roadblocks are removed, we should see more inventory that moves from shadow inventory to visible inventory and finally through foreclosure and on to the market.

Until the spigot of inventory is opened wider, the flow of properties will be slow, prices will remain inflated, and shadow inventory and squatting will continue unabated.  The Ponzis inflated house prices with their quest for appreciation income, and now inflated prices are supported by allowing the Ponzis to squat in their castles of debt. What was the Ponzi economy is now the squatter economy.