Why housing bears are probably wrong about the impact of “shadow inventory”

According to housing bears, banks are withholding from the market a “shadow inventory” of  millions of foreclosed homes. When these houses are put up for sale, the argument goes,  the supply of foreclosed homes will overwhelm demand, resulting  in another crash in housing prices. As my favorite housing bear David Rosenberg put it,

“the supply data have been distorted in part because of all the inventory that has been held off the market on bank balance sheets, but this cannot last forever. Estimates we have seen, peg the “shadow” inventory at 7 million housing units — those in foreclosure, those just entering the process, and those that have been in arrears for the past year but have yet to receive a notice. Tack these on to the “official” unsold inventory count of 3.6 million and what we are talking about is an overhang equivalent to 25 months’ supply. It is truly hard to believe that home prices are doing anything more than a wiggle right now in a long-term downtrend…”

Now, Mr. Rosenberg is a smart cookie. There is no question he is right about there being large numbers of foreclosures are in the pipeline, and there is no question that this will put downward pressure on housing prices (or, rather, limit price appreciation).  Nonetheless, there are a couple of problems with the bearish “shadow inventory” argument.

To start with: According to the latest foreclosureradar.com report, there is no shadow inventory of bank-owned homes being intentionally withheld from the market. On the contrary, banks have dramatically reduced their inventory of foreclosed homes. (See, e.g., Sacramento.)  So when we talk about “shadow inventory” we are really talking about homes that are in the early stages of foreclosure or  have not yet been foreclosed on, such as (in Rosenberg’s words) “homes that  have been in arrears for the past year but have yet to receive a notice.”

But such homes aren’t likely to flood the market in the the next few months. Instead, they will probably dribble out onto the market over a period of years, greatly reducing market disruptions. (Keep in mind that demand for foreclosures is very, very strong.)  Why are we looking at a period of years rather than months before these houses hit the market?

1) Massive amounts of foreclosures are clogging up civil courts in post-bubble cities, tripling the amount of time it takes to to move from initial filing to final judgment and auction.

2) Recent judicial rulings will likely slow down the foreclosure process. According to the Kansas City Business Journal, a late August ruling by the Kansas Supreme Court “undercut the business model for one of the mortgage industry’s key players — an intermediary that monitors mortgage sales and transfers for mortgage holders — saying the company lacked legal standing to receive notification of a home foreclosure in a case coming from Ford County in Southwest Kansas.” Details here.

The Boston Globe reports that a separate ruling by a Massachusetts Land Court justice late last week  puts into question the ownership of hundreds — and possibly thousands — of foreclosed properties in Massachusetts.

If we believe the most bearish estimate, the “shadow inventory” in the U.S. consists of 7 million homes. Let us assume, for the sake of argument, that every one of those homes ends up in foreclsoure and is placed on the market.   Let us assume, further, that because courts are clogged and because banks have difficulty proving ownership, it takes about two years for this to occur. (Keep in mind we are talking about homes that are either in the early stages of foreclosure or that  have not yet entered the foreclosure process.)   If 7 million foreclosed homes hit the market over a period of two years, that would mean an average of 875,000 foreclosures per quarter for each of the next 8 quarters. By comparison, a total of 937,840 homes received a default or auction notice or were repossessed by banks in the third quarter of 2009.

The “shadow inventory” is certainly a problem for the housing market, but it is not necessarily an unprecedented or insurmountable one. The weight of evidence suggests that the long-term downward trend in housing prices is over.

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6 Comments on “Why housing bears are probably wrong about the impact of “shadow inventory””

  1. AVeryRoughRoadAhead says:

    I came over from the “Fifty Years of Economic History in one Figure” post at Marginal Revolution.

    “The weight of evidence suggests that the long-term downward trend in housing prices is over.”

    For that to be true, wouldn’t a) unemployment have to stop rising, b) interest rates have to remain low, and c) the “shadow inventory” has to stop growing?

    But there’s no evidence that unemployment is going to be better anytime soon, only that the rate of job loss is slowing.

    If the Federal gov’t tries to keep borrowing capital-t Trillions of dollars every year, interest rates MUST go up, (and the Feds do plan to keep borrowing trillions).

    The bulk of the Alt-A mortgage payment adjustments are still ahead, not behind us, suggesting strongly that the rate of mortgage distress will continue to increase.

    Further, reversion-to-mean arguments suggest that nationally, home prices have another 30% to fall. See Robert Shiller’s 1890-2005 real home price chart, with additional commentary about why we may not mean-revert.

    So while it’s possible that the bottom is in, it’s not probable, IMO.

  2. AVeryRoughRoadAhead says:

    For instance, one of the “related post” headlines is:

    “Las Vegas Down to 3-Months Inventory of Homes – and Buyers Are Going Crazy”

    Which is amusing because it’s probably literally true – people buying houses in Las Vegas may be mentally unbalanced, or at least irrational.

    One would have to be convinced that an economic recovery was right around the corner to buy a house in a city ENTIRELY SUPPORTED by casual tourists whose sole purpose is to spend money, rather than view, tour or relax.

    A sucker bet.

  3. writejesse says:

    Thank you for your thoughtful comments. you write:

    “For that to be true, wouldn’t a) unemployment have to stop rising, b) interest rates have to remain low, and c) the “shadow inventory” has to stop growing?”

    with regard to (a) bearing in mind that the recession is over and most stimulus money has not been spent and “baked in” monetary stimulus has yet to completely work its way through the economy, I do think the economy will be very strong in the coming year. I believe, further, that at 10.2% unemployment is very close to the peak. When the unemployment rate starts to decline, probably in early to mid-2010, that will strongly reinforce the recent upward move in housing prices.

    with regard to (b), yes, mortgage rates probably will rise (assuming the Fed stops buying up mortgage securities) and, yes, to some extent this will put downward pressure on housing prices. So I agree with you here. This will be a formidable headwind for housing, but it won’t necessarily be enough to halt the bull market in its tracks. For example, mortgage rates increased by about a percentage point between 2003 and 2006, yet housing prices went way up during that period.

    with regard to (c), a shrinking shadow inventory is not a prerequisite to a bull market in housing. the issue here is how long it takes for these homes to hit the market. So far, the evidence suggests these houses will come to market in dribs and drabs over a long period of time. If that’s the case, housing prices can continue to rise even if the shadow inventory is increasing. Indeed, that is precisely what has been happening the past few months.

  4. Kibbutz says:

    Interesting.

    But saying that “mortgage rates increased by about a percentage point between 2003 and 2006, yet housing prices went way up during that period” ignores the fact that lending standards were decreasing during that period, increasing demand.

    My guess (and hope) is that lending standards (i.e. liar loans, interest-only, no/low down payment) will not return again.

    Although we’ll probably see even more “buy a house, get a check” promotions from Uncle Sam.

  5. […] housing bears, how’s that “shadow inventory” thesis working […]

  6. […] that massive “shadow inventory” of foreclosures that housing bears keep talking about? Where is it? Not in Orange County, […]


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