While there’s mounting evidence that an economic recovery is under way and picking up steam, there’s still no escaping the reality that roughly 7 million U.S. homeowners are either behind on their mortgages or in the foreclosure process.

If you consider nearly all of those homes to be "shadow inventory" — as analysts who track the performance of mortgage-backed securities did in one report last year — it’s difficult to imagine that there’s not more turmoil ahead in some housing markets.

But estimates of the size of the shadow inventory overhang vary widely, ranging from as few as 770,000 homes to nearly 7 million.

Editor’s note: This series shines a light on the "shadow inventory" of distressed properties that haven’t yet reached the market. Part 1, "Fears of an REO glut persist," explored the various definitions and projections for shadow inventory, and this article, Part 2, details the potential impact of this inventory on the housing market as a whole.

While there’s mounting evidence that an economic recovery is under way and picking up steam, there’s still no escaping the reality that roughly 7 million U.S. homeowners are either behind on their mortgages or in the foreclosure process.

If you consider nearly all of those homes to be "shadow inventory" — as analysts who track the performance of mortgage-backed securities did in one report last year — it’s difficult to imagine that there’s not more turmoil ahead in some housing markets.

But estimates of the size of the shadow inventory overhang vary widely, ranging from as few as 770,000 homes to nearly 7 million.

The wide range is due largely to differences in the way the term is defined, and on the assumptions made when calculating how many distressed borrowers are likely to lose their homes in coming years (see Part 1, "Fears of an REO glut persist").

Whatever the actual "shadow inventory" number is, the impact those homes will have on prices is expected to vary significantly from market to market, and depend largely on whether they are introduced gradually or all at once.

The threat posed by shadow inventory should also be viewed in the overall context of supply and demand, a picture that includes drastic cutbacks in new-home construction during the recession as well as expected growth in household formation and pent-up demand for homes.

According to some who have been tracking homes through the foreclosure process throughout the downturn, the threat posed by shadow inventory has been hyped.

Sean O’Toole, the founder and CEO of ForeclosureRadar.com, remembers a time when the term was narrowly defined to mean homes that had been repossessed by lenders, but not yet listed for sale.

By that definition, O’Toole said, there is effectively no shadow inventory in California today, because lenders are disposing of properties as fast as they acquire them.

O’Toole said lenders in the state are trying to dispose of about 90,000 homes, a number that represents about seven months of inventory.

"It takes banks an average of seven months to resell a foreclosed home, so they have essentially no REO (bank-owned property) inventory," O’Toole said. "They have exactly the inventory they should have — it’s moving through the pipeline — no surprises there."

The term shadow inventory became popular after O’Toole and others tracking foreclosures noticed that many homes they knew had been repossessed by lenders weren’t showing up for sale in multiple listings services or in reports tracking loan performance.

In the summer and fall of 2008, O’Toole said, he and real estate analyst Mark Hanson started using the term "shadow inventory" to describe those homes.

"Myself and a couple of others coined this term, which originally meant bank-owned properties that weren’t hitting the MLS" or showing up in reports, O’Toole recalled. "They literally disappeared into the shadows."

At the January 2009 Inman News Real Estate Connect conference in New York City, RealtyTrac Senior Vice President Rick Sharga revealed that the company had cross-checked a portion of the REO properties in the company’s database against properties listed for sale in the MLS, and discovered that 75 percent had yet to hit the market.

In a story headlined "Banks to unleash flood of REOs," Inman News reported warnings by Sharga and other analysts that inventories of unsold homes were likely to swell in coming months, as lenders put a backlog of repossessed homes up for sale.

According to data collected by Lender Processing Services, REO inventories did in fact grow by nearly 14 percent in 2009, breaking the 1 million mark in August.

But compared to the even more dramatic growth in the number of homes in the foreclosure process — which according to LPS grew by 71 percent last year, to 2.5 million — the increase in REO inventories was measured.

Instead of being inundated with a flood of REOs in 2009, many markets saw inventories shrink and prices stabilize as investors, along with homebuyers seeking to cash in on the first-time homebuyer tax credit, competed for bargains.

No conspiracy

Some observers have speculated that lenders and the companies they hire to service loans and handle loss mitigation have been intentionally withholding properties from the market in order to prop up home prices. Others maintain that lenders are simply overwhelmed by the volume of foreclosures and REOs. …CONTINUED

It’s now understood that lenders will always have more homes in their REO inventory than they have listed for sale because of the time it takes to prepare foreclosed properties for disposition. After taking title to a home, lenders must often evict the current occupants and make repairs to the home before putting it on the market.

The REO properties listed in the MLS typically represent one-fifth to one-seventh of total REO inventory, O’Toole said, because of the time it takes to prepare and sell foreclosed properties.

Sharga said RealtyTrac now has access to about 2 million MLS records and that, over time, the company has observed that about 20 percent of properties in foreclosure and 30 percent of REOs are listed for sale on the MLS.

The National Association of Realtors, in a recent estimate of shadow inventory, made similar assumptions. NAR assumed that about 75 percent of the more than 1 million homes identified as REO by LPS in January — about 770,000 homes — were not yet on the market.

Similarly, among the roughly 3.2 million homeowners who were in the foreclosure process at the end of 2009 or likely to be in that situation soon, NAR assumed that nearly one in four had probably put their homes on the market in the hopes of pulling off a short sale. That assumption was based on NAR surveys showing that distressed sales currently account for 24 percent of existing-home sales.

In other words, if shadow inventory is defined as REO homes not yet on the market, the number is well under 1 million homes and has stayed fairly constant for the past 18 months.

And if the definition of shadow inventory is expanded to include some portion of borrowers who are delinquent or in foreclosure, a significant number of those homes are probably already on the market — a fact not taken into account in some shadow-inventory estimates.

O’Toole believes that some analysts who predicted that a huge wave of foreclosed properties would hit the market in 2009 are responsible for expanding the definition of shadow inventory to include not just homes in the hands of lenders, but also a sizable percentage of non-current loans.

"They were wrong. Some of the best bargains were picked up in March of last year because of all this fear around the foreclosure inventory," O’Toole said. "So the analysts who completely had that wrong, rather than saying we were wrong, came back and rejiggered the term to include loans in the foreclosure process, and then loans in delinquency.

"There are even some blogs saying, ‘We have a lot of people out there who would like to sell, but not at these prices,’ and that’s being called shadow inventory," O’Toole said. "The definition kept expanding."

If the relatively flat growth in REO inventories punched a hole in the theory that lenders are intentionally withholding properties they’ve repossessed from the market, the fact remains that loan servicers are managing an enormous pool of non-current mortgages.

But O’Toole thinks it’s stretching to label those loans as shadow inventory. While the ultimate fate of those loans is uncertain — not all borrowers who are foreclosed on or miss payments will end up losing their homes — their current status can be determined.

"We take issue with (homes) in foreclosure being called shadow inventory, because we can tell you the status of each and every one of those properties," O’Toole said. "It’s not in the shadows."

Data gathered by the HOPE NOW alliance of loan servicers shows that lenders started foreclosure proceedings on about 6.1 million homes from July 2007 through the end of 2009. But during that time, loan servicers completed only 2.2 million foreclosure sales.

"We would have a smoking crater where there used to be a real estate market" if all the homes that enter the foreclosure process or that are headed there now suddenly came to market, Sharga said. "That’s not how the system works."

Extend and pretend

Although the rate at which good loans are going bad appears to have flattened or gone into decline, there’s continued growth in the number of severely delinquent loans and homes in foreclosure.

Lenders are taking longer to close out bad loans, which has helped prevent explosive growth in REO inventories. But it’s also raised the question of whether lenders are playing a game of "extend and pretend," prolonging the day of reckoning for many housing markets.

"There is a huge shadow inventory of folks not making their payments," O’Toole acknowledged, and it remains to be seen how many of those borrowers will be helped by the Obama administration’s loan modification and short-sale incentive programs.

But O’Toole thinks it’s unlikely that borrowers who can’t be helped will be moved through the system so quickly that housing markets will be flooded with REO properties, as some have predicted.

At the current rate lenders are liquidating property in California, O’Toole thinks it could take them three years to work through all the inventory that would be created if every homeowner in the state who’s currently behind on their mortgages or in foreclosure — upwards of 1 million — did in fact end up losing their home. …CONTINUED

O’Toole takes a dim view of the government’s Home Affordable Modification Program (HAMP) because, in his view, it’s well-intentioned but leaves homeowners "prisoners to debt" while delaying needed price corrections.

The carrot-and-stick measures that state and federal lawmakers have instituted to slow down the foreclosure process and encourage loan modifications mean that lenders are waiting longer to start foreclosure proceeding on delinquent loans, and that the foreclosure process itself also takes longer.

ForeclosureRadar’s chief operating officer, Mark Skilling, recently testified before California lawmakers that it now takes homes an average of 226 days to move through the foreclosure process in the state. That compares with 145 days before California passed several laws creating new hoops for lenders to jump through in the foreclosure process.

O’Toole doesn’t think prices would plummet if lenders could speed up the pace at which they foreclose on properties and put them back on the market.

In his view, home prices collapsed because lenders stopped offering "ridiculous loan products" that enabled borrowers to purchase homes they couldn’t really afford. O’Toole believes prices will continue falling until they reflect buyers’ incomes, and that this will happen regardless of whether or not the supply of foreclosures is artificially constrained.

O’Toole also doubts that the Obama administration’s short-sale incentives initiatives, the Home Affordable Foreclosures Alternatives (HAFA) program, will generate a wave of short sales. He believes lenders, and the financial system as a whole, aren’t capable of sustaining the kind of losses that would entail.

"Last year, I think we were the only ones who said we wouldn’t be seeing this huge wave of (REO properties)," O’Toole said of predictions he made on his blog last year. "This year, it feels like deja vu, with everybody gearing up for short sales. Once again, people are going to be disappointed.

"There will be short sales, just not the deluge people are expecting," for the same reason lenders are dragging out the foreclosure process: because they are in no position to recognize those losses right now, O’Toole said.

"Ultimately, through ‘extend and pretend,’ we’ll get there," O’Toole said of the time it will take to work through the steady stream of foreclosures he foresees — perhaps as long as 10 years.

"If we get some inflation, it could go even faster," because that would boost incomes, O’Toole said. "But inflation is really painful, and wages go up last, which is why the Fed talks so much about heading it off."

RealtyTrac’s Sharga believes that a slow and steady flow of distressed properties into the market will benefit Realtors specializing in such transactions, as well as buyers who have been too timid or unable to test the waters so far.

"If you’re a Realtor, if you are not involved in the distressed-property marketplace right now, and have no interest in it, it probably means you are in for another year of hard times," Sharga said.

But distressed property specialists probably have "a few more years of opportunities at your fingertips," he said. "If you are a homebuyer, the word is patience — if you don’t get one today, there will be plenty of opportunities in coming years."

Supply and demand

It may be that homebuilders, lenders and investors in mortgage-backed securities have the most to fear from shadow inventory and pent-up supply.

"For homebuilders, there is no good spin I can put on this," Sharga said of the shadow inventory overhang.

Although the recession has taken a toll on builders’ bottom lines, drastic cutbacks in new-home construction could also mitigate the impacts of any shadow inventory that does come onto the market.

Single-family housing starts, which rarely dip below 1 million a year, hit a record low of 445,000 in 2009 — a 74 percent decline from the peak of 1.7 million in 2005. The Mortgage Bankers Association projects that it will be 2012 before housing starts reach the 1 million mark again (see chart).

While the rate of homeownership has taken a hit during the downturn, new household formation is expected to rise, providing a potential source of demand. …CONTINUED

Analyzing the state of the nation’s housing markets in a report last year, economists with the Joint Center for Housing Studies of Harvard University forecast strong household formation in the decade ahead, despite the impact the recession is expected to have on immigration.

With echo boomers entering their peak household formation years of 25-44, household growth could total as much as 14.8 million between 2010 and 2020, the report predicted, or remain closer to 12.5 million if immigration remains constrained (see story).

Demand could be stunted by persistently high unemployment and the more than 11 million homeowners who are "underwater" on their mortgages — they owe more than their homes are worth. 

Economists with the UCLA Anderson Forecast say they see little possibility of a "double dip" recession, but expect job growth will be sluggish through 2012. Millions of borrowers who have been through bankruptcy or foreclosure will also need time to repair their credit scores before they can qualify for a mortgage again.

New household formation is expected to pick up as companies start hiring again, spurring demand by both former homeowners and first-time homebuyers.

Of course, a recovery will also spur would-be sellers who’ve been waiting on the sidelines to put their homes on the market. Some have also characterized this "pent-up supply" as shadow inventory — although, unlike an REO sale, many of those transactions will also involve a purchase by the seller, who will often be trading up or downsizing into a smaller home.

A survey of homeowners conducted during the third quarter of 2009 by Zillow found 8 percent would be "very likely" to sell if market conditions improved. The survey was reported in the news media as evidence of a "shadow inventory" of 10 million homes.

Zillow Chief Economist Stan Humphries expects that pent-up supply will come onto the market in fits and starts, like a lawnmower engine that’s revved and then sputters when it’s fed too much gas. Prices will serve as a throttling mechanism, he said, with sellers holding properties off the market when the rush to sell creates too much supply.

Humphries expects home prices to hit bottom in June, and then stay flat for three to five years because of the enormous reservoir of inventory that’s yet to hit the market.

It’s a given that the impact of shadow inventory and pent-up supply will vary from market to market.

Although foreclosures have bloated inventories in some markets — particularly Rust Belt areas with persistently high unemployment — sales of distressed properties have been brisk in regions with strong job centers.

"Things are fundamentally different in (places where) you have a structural problem and industry and population have declined," O’Toole said. "The only thing that fixes housing in those regions, where you have more houses than people, is a bulldozer."

According to an index compiled by mortgage insurer PMI that attempts to predict the chance of price declines in a given market in the next two years, risk scores declined in 212 of 384 markets during the third quarter of 2009.

But 221 of the markets tracked by PMI’s U.S. Market Risk Index still had a greater than 50 percent chance of price declines. Those markets typically had higher unemployment rates, higher new foreclosure rates, lower affordability, a larger excess in housing prices, and more price volatility than the 163 markets with minimal to moderate risk of price declines, PMI said.

Of the top 50 markets by population, the Detroit area had the highest unemployment rate — 18.5 percent — and a 99.6 percent probability of further price declines in the next two years, the report said.

Illinois and Ohio showed the largest gains in risk, but markets in the "sand states" — Florida, California, Nevada and Arizona — had the highest risk scores.

PMI’s analysis grouped 30 of the 50 nation’s largest housing markets, including Las Vegas and Phoenix, in the same high-risk category as Detroit. In Florida, the riskiest markets were Miami, Ft. Lauderdale, Tampa, Jacksonville and Orlando. California’s riskiest markets were identified as Los Angeles, Santa Ana, San Diego, Sacramento, Oakland, San Jose and San Francisco.

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