Must-sell shadow inventory has morphed into can’t-sell cloud inventory

According to Zillow about 30% of mortgage borrowers are underwater. If you factor in sales commissions and transaction costs, the number is closer to 50%. When you reflect on it, what does an underwater borrower really own? They don’t have any equity, and since their underwater, even if prices go up, they still won’t have any equity. Perhaps they have the hope of equity, but the only tangible thing they own is their loan — that’s why I often refer to them as loanowners. It’s probably more accurate to call them money-renters because without an equity stake, they are merely renting money from the bank for the privilege of living in the bank’s house.

There isn’t much difference between a loanowner and a renter. Neither one has equity. Loanowners have hope of equity, but they also have the fear of trashed credit and debt collection if they want to move before the value of their house rises enough to make the equity dream a reality. Renters don’t have hope of equity, but they have the freedom to leave the properties they are living in with relatively few constraints. If a renter does not like the property or the price, they have the ability to leave and find a better place. The landlord has no leverage to force the renter to pay more than market rates. Not so with a loanowner.

The necessity of loan modifications

Ostensibly, loanowners and lenders agreed to the price of money (interest rate and payment) when the promissory note was signed. Unfortunately, during the housing bubble, the terms of these notes were onerous, and many borrowers faced excessive monthly housing costs while simultaneously facing declining house prices and the elimination of their equity. This prompted many borrowers to strategically default, and lenders are very worried that more would follow. Banks are still exposed to $1 trillion in unsecured mortgage debt. The threat of strategic default and the reality of a trillion dollars in unsecured debt forced the banks to renegotiate the terms of the original promissory note, and loan modifications became a feature on the real estate landscape.

Lenders don’t want to make loan modifications. If the borrowers had equity, they would simply foreclose on them and get their money back. Since so many are so far underwater, the banks can’t foreclose on them and get all of their money back, so it’s in their best interest to cut deals, amend loan terms, kick the can, and pray these borrowers will make payments until prices come back. At that point, things change back in favor of the banks, and their motivation to be accommodating and make loan modifications will vanish. Many people have come to view loan modifications as a new housing entitlement. It won’t be. The moment borrowers are no longer underwater, the entitlement will be rescinded by the banks. Remember, they would rather foreclose and get their money back so they can loan it to someone who will make payments based on the original contract terms.

The money rentership negotiation

The negotiation of terms for loan modifications is unique. Never have so many been in such circumstances, and there is no precedent for this activity. The lender has far more power than a landlord because the eviction of a loanowner (also known as a foreclosure) trashes the credit score of the borrower. This gives lenders the ability to demand payments for renting money that exceed the fair-market rent on the property — and loanowners will pay it.

For example, let’s say a loanowner is facing a $3,500 payment on a property that rents for $2,000 — a common occurrence in the aftermath of the housing bubble. The borrower could simply strategically default and squat until the lender forecloses then go rent a similar property for $2,000 per month. Many do. However, after examining the borrower’s finances, the bank may offer a loan modification that reduces the payment to $2,500 interest-only on a temporary basis if the borrower starts paying again. Since the bank makes up the formula anyway, they can spit out whatever number they think they can get the borrower to pay. Since the borrower has credit consequences to walking away in favor of rental, and since the borrower has hope of future equity, many borrowers will pay the extra money to stay in the house.

The win-win of rising prices

Every underwater loanowner is a potential loss for the lender. If that borrower stops paying or asks for a short sale before prices reach peak valuations, the bank will take a loss. Banks don’t want to recognize losses either by foreclosure or short sale. They would far prefer to borrowers to stay in their homes, pay something, and wait for house prices to reach the peak where lenders have no exposure. Most loanowners are happy to play along. The only thing lacking up through early 2012 was rising prices to give both lenders and loanowners hope. To get prices to go back up, lenders needed to drastically reduce the MLS supply to create a false shortage the forces buyers to compete and bid prices up. Once prices started to rise, and once loanowners started to believe the rise was sustainable, many of them signed up for loan modifications and decided not to sell their house as a short sale to avoid the credit consequences. As far as lender and loanowners are concerned, this is a win-win. The only losers in this scenario are future homebuyers, and as I’ve pointed out before, nobody cares about them.

Cloud Inventory: the morphing of shadow inventory

Housing bears all look at the huge numbers of delinquent and underwater borrowers as potential future must-sell inventory. As I pointed out in Las Vegas: a case study in successful housing market manipulation, the relaxation of mark-to-market accounting rules circumvented the normal market-clearing mechanisms that would have forced the sale of millions of properties. As a result, shadow inventory kept waiting in the shadows, and it never hit the MLS. Finally, lenders went “all in” betting on success of loan modifications because each modified loan is one less unit languishing in shadow inventory, and one less potential sale for a loss through foreclosure or short sale.

So does that mean that shadow inventory is gone?

No. It’s merely changed its form.

Very, very few loan modifications will end up with owners staying in the properties much past the point when they are no longer underwater. Remember, these people needed loan modifications because they couldn’t afford to service the debt on the home, and contrary to popular myth, it isn’t because of temporary conditions like job loss in the recession. Most people simply over-borrowed as evidenced by the appalling debt-to-income ratios reported on “successful” loan modifications. Some of these people simply had bad timing, but many were Ponzis who took free lender money and spent it. Either way, these people can’t afford their homes without the loan modification, and the generous terms of the loan modifications offered when the borrowers were underwater will be much less generous once the lender can foreclose and get all their money back. Many borrowers will be compelled to sell as an equity sale once they have equity again.

Cloud inventory is the borrowers who will be compelled to sell by rising mortgage costs once they have equity again. I call it cloud inventory because these sellers are trapped in the clouds waiting for prices to rise enough to give them an exit point. We know there are millions of people trapped in the clouds by the lack of current MLS inventory. The low housing inventory is an indicator of residual mortgage distress.

Cloud inventory is clustered near peak pricing

The borrowers trapped in cloud inventory all have different price points where they can exit depending on (1) when they borrowed, (2) how much they borrowed, (3) the terms of their loan modification, (4) how much was added to the balance when they got the loan modification, and (5) whether they survived this long. Let me take these one at a time.

When they borrowed

Not everyone bought at the peak or maxed out their HELOCs at the peak. Many did, but not all of them. Further, some of these borrowers used amortizing loans and their balances have been decreasing over the last 7 years. The timing of the borrowers loan relative to the peak sets the baseline for where they are today.

How much they borrowed

Some people did not borrow 100% of the purchase price or appraised value of the home. Many did, but not all of them. Those that didn’t max out their borrowing also have a baseline somewhere less than peak valuation.

Terms of their loan modifications

Mark Hanson has pointed out on many occasions that the terms of loan modifications are even more onerous than subprime. Teaser rates, interest-only, increased loan balances, high debt-to-income ratios, basically everything done wrong in the bubble is being done again in a desperate attempt to get a few more payments out of these borrowers. Most of the more favorable terms are set to expire in the future creating a recast and reset problem similar to the ARM wave which caused so many of the delinquencies we have today.

How much was added to their balance

One of the most common feature of loan modifications is an increased loan balance. Most people had to quit paying their mortgages to be considered for a loan modification, and then the process often took many months. Once the loan modification was finally approved, banks typically added up the missed payments, late fees, servicing costs, and anything else they could reasonably charge the borrower and added it to the loan balance. Many people who’ve received loan modifications owe 5% to 20% more than their original loan balance. This feature of loan modifications ensures that distressed inventory will be with us even once we get past peak pricing.

Did they survive?

Many of the people in shadow inventory and now cloud inventory won’t sustain ownership long enough for prices to rise enough for them to sell and pay off the loan. Millions of short sales and foreclosures have already occurred, and millions more short sales and foreclosure will occur before this is done. The more prices must go up to bail the borrower out, the less likely it is to happen. Lenders know this too, and it’s why they’ve given principal reductions to the most deeply underwater borrowers. They want them to be close enough to the surface that they still have hope. Without hope, they won’t pay on their loan modification, and the lender will be forced to foreclose and take a loss.

Cloud inventory is the new market overhang

Shadow inventory was a threat to the housing market because if must-sell inventory hits the market, prices go down. We all saw that in 2007-2009. Cloud inventory is fundamentally different. It isn’t must-sell shadow inventory; it’s can’t sell cloud inventory. We know the inventory is there, and when market prices rise enough to enter the clouds, this inventory will appear and buyers must push through this inventory to move prices higher.

Prices will continue to rise rapidly until interest rates go up or until they reach their normal friction point of affordability. My monthly reports still show prices are about 25% below their affordability limits, so we have plenty of room to move higher. At this point, I would estimate prices will rise 25% over the next three years, depending on what interest rates do. As prices get closer to the peak the cloud inventory will start to appear, and the rate of appreciation will slow. Of course, by then the kool aid intoxicated bulls won’t believe the party won’t go on forever, but cloud inventory is out there, and it will take many years to push through it all and get back to a market where sellers have equity and buyers aren’t subsidized.