A number of people have asked me recently what I thought of the "shadow inventory" that the banks have. The concept of shadow inventory is simple. It's composed of house which have been foreclosed upon and which the banks are holding in their REO departments and not releasing to the market.
The shadow inventory basically amounts to a huge (excuse me for the weak humor) shadow on the real estate market. Let me explain. We're currently seeing a shortage of inventory in our metro area market. Homes in the lower and lower-mid-price ranges are often selling quickly with multiple offers. Yet, there are many, many obviously vacant homes in the same neighborhoods. A brief investigation of the county tax roles shows that many of the vacant homes are owned by banks. Why aren't these on the market? And, what would happen to the market if they were released to it in a group?
Both good questions.
The reason they aren't on the market is that the whole system is over-leveraged. When values drop as they have, collateral disappears and there is no more foundation for additional leverage. There are only two tools to use to try and effect a cure for this situation. The first is to allow banks to claim non-existent assets as reserves and the second is to lower interest rates so buyers can qualify for ever greater mortgages.
We're currently suffering from the results of over-application of the second tool. If we enable the banks to loan out 10 dollars for every one dollar held in reserve, then every dollar in the system will support 10 dollars in debt. If one of the dollars of debt goes bad through failure to pay, the banks then have no reserve. If two of the dollars go bad, then the lenders are insolvent. Unless, you lower the reserve requirement. If you lower it so that every dollar supports 20 dollars in debt, then the lenders are back in business. We're reaching the end phase for this strategy. If you keep this up, eventually your pocket change will allow you to justify a million dollars of debt. You can see how this quickly becomes unsupportable.
The application of the first tool is the cause of the shadow inventory problem. If the lender owns a vacation property in Orlando which has a market value of $100,000 and the bank's mortgage was originally for $200,000, if the property were sold, the bank would have to accept a $100,000 loss.
The bankers are smart. They all want their end-of-year bonus and running the bank into the ground isn't going to get them that. So, what to do? Obviously, keep the property in the REO department and show it on the books as being worth $300,000. The $100,000 loss goes away and the bank also has an additional $100,000 to leverage into more debt. Why sell any foreclosures at all? In fact, it might be better to slow down the rate of foreclosures and let the owners stay in the properties and maintain them.
Of course, the lenders are just as aware as the real estate sales community of the potential effects of dumping the entire shadow inventory on the market. An oversupply would have the immediate effect of grossly suppressing prices in an already marginal market.
Their strategy to gradually leak their inventory onto the market is an obvious one. An additional strategy may be to sell large numbers of houses to private investors with the proviso that the properties become rentals which may not be sold for some number of years. The major problem with this strategy is that it would have the net effect of reducing rents in the impacted markets and that would, of course, reduce values because value in the rental market is determined by cap rate. A reduction of the value of the rental market would impact the resale market as well.
So, what's going to happen? Ultimately, regardless of good or ill intentions and efforts to support the system, reality will win out and values will have to adjust to a supportable level. It looks as if this is going to be a painful process.
The only question left is how long will it take. Do you like to rip bandages off quickly or pull them off slowly? In terms of the housing market, I'm of the opinion that the quicker you reach the bottom and quit messing with the situation, the quicker it will begin to heal itself. Unfortunately, this does not seem to correspond well with the politicians urge to avoid painful economic issues which may impact the chances for re-election, so I suspect we'll see the government continue to attempt to intervene in order to drag the process out as long as possible.
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