Implications of Foreclosure Inventory Growing

Foreclosed homes may be hitting the market at lower rates, but they continue to bloat bank balance sheets. A front page New York Times article today investigates the phenomenon of banks accumulating foreclosures, rather than quickly releasing them to the market. This is likely occurring both voluntarily and involuntarily. On one hand, foreclosuregate drove banks to slow their processes. On the other hand, banks don't want to vomit hundreds of thousands of foreclosures on a small group of interested buyers. How will their strategy affect the housing market?

Why It's Happening

First, why are banks choosing to act in this way? There's really no upside to foreclosing quicker. Home buying demand remains relatively weak. This means auctions will provide deeper discounts if more homes are offered to few buyers. Even the broader housing market will provide bigger discounts on distressed properties if there are more to choose from.

Additionally, as banks foreclose slowly, the losses that result hit over a longer period of time. That makes them easier to digest, as revenue each quarter will more easily outweigh those losses. If they come all at once, they could deplete a bank's capital, which could cause investors to grow wary.

Moreover, if banks were to process foreclosures more quickly, they would have to ramp up their staffs. In other words, their costs would increase.

So really, the calculus becomes a simple one for banks. Do you want to increase your costs and increase the size and severity of the losses you take on foreclosed homes? Of course not, so you foreclose slowly.

Longer To Rebound

What's good for banks isn't necessarily good for everybody else, however. Although they may succeed in preventing prices from falling more quickly than they otherwise would, they cannot prevent prices from falling altogether. That's a function of supply and demand. The demand isn't going to rise or fall based on that supply alone. So whatever equilibrium housing prices would have reached if foreclosures were processed quicker will still be where they end up. Banks are just choosing to take the longer road there instead of the shorter one.

A Fake Rebound

Yet it might look like banks are succeeding at preventing bigger declines in prices. Inflation might make the market look better than it really is.

For example, if prices increased by 1% for the next three years, but inflation increases something around 4% per year, then real home prices had declined by around 9% over the period. Under normal market conditions, homes appreciate with inflation, so what looks like a rebound might not be in real terms.

A rebound will not be present until home prices increase at or above the rate of inflation. Dragging out the time it takes to hit the bottom will likely cause tiny nominal gains in prices for a few years, which really translate into losses.

No Overshoot?

But the banks may accomplish one thing: they may prevent a market overshoot. If lots of foreclosures were released immediately, and home prices were to fall all at once, instead of over an extended period, then homeowners could freak out. You might see strategic defaults begin to soar again. If the housing market were suddenly to fall by, say, 10% or more in a year, then more underwater borrowers might walk away.

This could cause the market to overshoot its natural bottom. That would be worse for everyone. So this could be one clearly positive consequence of banks' slow trickle strategy.

Better or Worse for Construction?

Is this strategy best for the construction market? This could play out one of two ways.

As foreclosed homes are being consistently, slowly released, some buyers might wait to see if good properties are forthcoming, rather than constructing a new home immediately if they don't like the listings they see. New construction would remain slower for longer.

Alternatively, if the discounts were deeper immediately, then buyers might renovate an existing property instead. Then, the relatively low levels of inventory out there (compared to a foreclosure dump) would encourage potential buyers to build sooner.

So for quite a while, the housing market is going to remain in this frustrating, slow state of uncertainty and weakness. A real recovery will be elusive, probably for years. But prices in most locations aren't likely to decline very quickly over this time either.