There's plenty of chatter to go around regarding Shadow Inventory? And it has been defined many different ways, some of which are incorrect. So let's get our arms around it and see if we can make some sense of this. Shadow inventory is housing units that are not making it onto the public market for one reason or another.
Much speculation has taken place as to "why" these properties are not coming to market...
- Lenders are overwhelmed and don't have the staff to handle the glut? Wrong answer.
- Lenders are simply don't have an efficient system in place to handle this mess? Wrong again.
- Lenders are arrogant and just don't care? Well, there may be some truth to that...but in this case, wrong again.
So what's the deal with lenders? And why might this Shadow Inventory be lurking about...in the shadows?
It all starts with the Banks capital ratio requirements. First - what is Capital Ratio? Banks are required by the Fed to maintain certain capital ratio's - meaning they are required to maintain a level of cash in relationship to the dollars they have loaned. The requirement is about 16-1, so they can lend 16 x the amount of cash on the balance sheet.
As a bank, if they take a loss in the form of a foreclosure, that loss goes against the capital account, reducing the amount of capital...so the bank has to raise more capital to stay in compliance, or call some loans due. And let's face it...with all the pre-foreclosures, that could be a very sizable hit to a capital account. It is easier for them to suck it up and take the monthly payment loss and carry the home a while rather than write it off and have to raise boatloads of capital.
Here is an example of how it works:
Let's say we decide to open a bank with $1,000,000 cash. That is our capital account. But we don't lend that out. We encourage people to bank with us and open a deposit account (maybe we'll pay 1/2%) and we take that money and lend it out at... say 8%. Our Bank makes the spread of 7.5%, called arbitrage. We take in as much in deposits and lend out as much as possible and keep increasing that spread. But we are limited though...we can only loan out 16,000,000 (16 x our capital account).
Even though we have tough lending practices, we still realize that some loans will lose money, some will default. When that happens, we cannot risk customer deposits, so our capital is at risk. As these losses occur, we must raise more capital. So let's assume that we have 16,000,000 outstanding and we lose $500,000 in foreclosures. That $500K comes out of our $1MM capital account...so now our capital account only has $500K and we must raise an additional $500K to be in compliance. OR...we can only lend out $8MM versus the $16MM we have outstanding. Which means we don't make as much in arbitrage because we can't have as much loaned out.
Well, as Board members of our Bank, we decide it would be easier, smarter, and cheaper to carry the loans on the books longer...maybe it cost a couple thousands per month and we can unload slowly. And maybe we get lucky while we wait, and the market turns and we unload them at a better price.
So it is safe to anticipate the banks will unload slowly instead of all at once.
Another thing to keep in mind with a potential foreclosure...The Bank is typically going to unload properties with the most amount of immediate equity. For instance, let's say a bank has 2 properties that go into foreclosure on the same day....both are $200K homes (market value today). One has an outstanding mortgage for $180K ($20K in equity), the other has an outstanding mortgage of $150K ($50K equity). The latter will be processed more quickly than the former. They will dump the mortgage for $150K and grab as much of the $50K equity sitting there, and be a little more patient with the home that has only $20K equity. So people who have 100% financing or are upside down in their homes are the safest bunch from a speedy foreclosure.
Need more info? Just give me a call or email me!
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