The "Shadow" Foreclosure Inventory

Sunday night, I returned from a quick weekend trip to my hometown in South Florida. It was my first time there since early January. Driving around Fort Lauderdale, it became extremely clear just how big a hit its economy has taken as a result of the real estate market's collapse. It's like a different world compared to what it was like just a few years ago: overgrown grass rises above many curbs and sidewalks; homes and businesses sit empty and abandoned; most blocks display multiple "for sale" or "for rent" signs. In speaking to some of my friends and relatives who still live there, I learned that the state's ongoing foreclosure glut has resulted in an interesting phenomenon -- a "shadow" inventory of foreclosures.

The Wall Street Journal has an article about this shadow inventory today. It explains what's going on in areas hard-hit by the housing bubble's pop:

Legal snarls, bureaucracy and well-meaning efforts to keep families in their homes are slowing the flow of properties headed toward foreclosure sales, even when borrowers are in deep distress. While that buys time for families to work out their problems, some analysts believe the delays are prolonging the mortgage crisis and creating a growing "shadow" inventory of pent-up supply that will eventually hit the market.

During my trip to Florida I heard about families who have lived in their homes as long as two years without paying, because the banks haven't gotten around to foreclosing. And that's a problem. Until the real estate market recognizes all its losses -- including accounting for all foreclosures -- it won't be able to regain real stability and move on. Of course, that has implications for the broader economy as well.

Here are two journal sources explaining how bad they think this problem is:

"There's going to be a flood [of bank-owned homes] listed for sale at some point," says John Burns, a real-estate consultant based in Irvine, Calif. When that happens, Mr. Burns believes, home prices will fall further, particularly in markets with large numbers of foreclosures. Overall, he expects home prices to decline 6% next year.

Ivy Zelman, chief executive of Zelman & Associates, a research firm based in Cleveland, believes three million to four million foreclosed homes will be put up for sale in the next few years. The question is whether the flow of these homes onto the market will resemble "a fire hose or a garden hose or a drip," she says.

All of that sounds pretty ugly. But what are the actual numbers as they pertain to this shadow inventory of foreclosures? They're hard to get exact, given the very nature of the problem -- these foreclosures have not yet been completed. But the Journal does provide some statistics to work with:

As of July, mortgage companies hadn't begun the foreclosure process on 1.2 million loans that were at least 90 days past due, according to estimates prepared for The Wall Street Journal by LPS Applied Analytics, which collects and analyzes mortgage data. An additional 1.5 million seriously delinquent loans were somewhere in the foreclosure process, though the lender hadn't yet acquired the property. The figures don't include home-equity loans and other second mortgages

Moreover, there were 217,000 loans in July where the borrower hadn't made a payment in at least a year but the lender hadn't begun the foreclosure process. In other words, 17% of home mortgages that are at least 12 months overdue aren't in foreclosure, up from 8% a year earlier.

The first quoted paragraph shows that there are at least 2.7 million foreclosures that have yet to hit the market. Some of those may be modified, but the vast majority probably won't. The second paragraph explains that the problem is getting much worse: the portion of homes not in foreclosure despite its borrowers not making a payment in a year has more than doubled compared to last year.

So why do we have this shadow inventory? There are three possible causes:

The first is explained in the WSJ piece. It's taking quite a long time to figure out which borrowers qualify for the Obama administration's mortgage modification program. It's also taking time to process the deluge of applications. During the wait, borrowers remain in their houses which, otherwise, would be in foreclosure. Those who don't get the modification will ultimately face foreclosure.

Second, with so many foreclosures, banks likely just have logistical issues getting them all processed in a timely manner. There's a heap of paperwork and other red tape involved in making a foreclosure happen. Banks have never experienced a flood of foreclosures like this, so they aren't equipped to handle so many very quickly.

Third, banks may not want to foreclose on all of these homes immediately. A WSJ source above used the analogy of foreclosures hitting the market like "a fire hose or a garden hose or a drip." Which do you think would be better for housing prices? The drip. If you have a huge inventory, then it's more of a buyer's market, where few buyers can drive down the prices of many homes. If you have the foreclosures spread out over a longer amount of time, new buyers may enter the market over that lengthened period. I have heard the theory (from a Floridian friend of mine who knows the real estate market there) that banks are purposely holding back foreclosures for exactly this reason.

Whatever the cause or severity, I believe that the shadow inventory of foreclosures is real. It poses a danger to the real estate market's recovery. How significant a debilitating effect it will have is still unclear.