Shadow inventory, should we be afraid of shadows?

A recent commentary said that there is something between 18 and 103 months of "shadow inventory" in the housing market. As a researcher I am interested in the range of the estimates. Presumably the shorter period assumes that the inventory is relatively small and will be absorbed quickly, the longer, obviously, the opposite.

First let's consider the definition of shadow inventory. Presumably this is, primarily today, property which is probable to come to market via foreclosure and sale. The clue as to its magnitude would be the number of mortgage defaults. A lesser indicator would be the number of homes which aren't worth their mortgages.

In the normal course of events most defaults are cured somehow. The back payments are made. Clearly the high estimate of shadow inventory must assume that a larger than usual proportion of defaults will come to market rather than be cured by being brought current. Alternatively the property is sold. Perhaps today it is sold for less than the mortgage amount with the lender's permission, a "short sale". Perhaps the borrower gives the property back, a deed in lieu of foreclosure or simply "jingle mail", which then leads to a sale by the lender. The number of "underwater" loans which will default is basically unknown. A "rationale man" argument would say that they've already been sold to the lender, so walk. Take the excess money that was loaned (possible if the loan in question was a refinance) and use it to buy the same thing cheaper. But time and again people have demonstrated that economic rationality is larger than math.

The low estimate could be based on a number of opinions. Starting with the "underwater", as long as people CAN make the payments, maybe they will. That leads to an opinion about the strength of the economy and employment. If the economy is strong, wages and employment grow, then even the folks who are seriously behind in their payments might bring them current.

Recently read a report that mortgage defaults are running for months, even maybe over a year. Curing that sort of default is going to be difficult. Even if the property started with equity in it, the default, penalties & interest, will eat that up. Of course if it didn't, how much worse would THAT be? What's happening here? Has downsizing overloaded the workout staffs? Have legal obstacles (borrower bankruptcy) gotten in the way of foreclosing? Is the property unattractive to own (think a burned out, board-up in a bad part of Detroit)? Is it difficult to pull the pieces together of all the lender parties-in-interest in a MBS/CDO to act? Or worse, has the slicing & dicing of the loan made it unenforceable (http://www.charlesbwarren.com/landmark.html )? In all events, this is the imponderable and somewhat scary part of the shadow.

For a while in the 1930s Bank of America was the biggest property owner in California. In many cases they made a deal: the borrowers stayed in the property, took care of it, even farmed it, and payed what they could. Bank of America took title, but agreed that when the economy straightened itself out they would work on restoring the property to its previous owners. Another tactic was with banks who would not renegotiate loans. Two neighbors might both default and be foreclosed. Each would buy the other's house at auction with new written down loans. Then there was "the nuclear option" in which all the neighbors crowded the auction and no strangers need attend. The winning bid WOULD be $1. At that point the winner would sell the property back to its original owner for $1. Of course, if it was a farm, life would still be rough. Credit would be even harder to come by for feed, seed, fuel...

Lurking in our present shadow may be zombies, trapped, never to see the light of day. Who owns a home with an unenforceable mortgage from which the defaulted borrower just walks (eventually probably the county for back taxes, but...)? What if they don't walk? How about property which would cost more in legal expense to foreclose than could be recovered on sale? Yet as nightmarish as these zombies seem, do they matter?

We already cope with failed neighborhoods, where the social decay is so advanced that some 3rd world countries look good by comparison. Somalia a failed state? We have failed cities. There is a generational failure and the grandparents who raised their grandkids will be incapable of raising their great-grandkids. The markets that apply in these areas are often black markets. The economic base is illegal activity supported by government transfer payments. Many of the zombies will descend into this pit, or the pit will expand to include them.

H.G. Wells had a similar vision in "The Time Machine". The privileged gambol in the gardens unless seized, from time to time, by the monsters which lived below. Simply speaking, the worst part of the shadow inventory would just cease to matter. Normal markets simply bypass it. Small fortunes were made by buying real estate at Depression era tax sales, but not generally large fortunes. Deeds to lots in paper subdivisions were given away as premiums at theaters. Decades later they might be little more valuable. My wife actually inherited a paper lot in the Arizona desert. Clearing the title would cost more than it's worth...

Charles B. Warren, MRICS,
ASA-urban real property
Pleasant Hill
925.609.7241
http://www.charlesbwarren.com/topics.html