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The term shadow inventory typically refers to homes that are not yet listed on the market and are either in the foreclosure process or owned by the banks. According to recent data from the Mortgage Bankers Association there are roughly two million homes in the United States that fit this category. This figure suggests that it could take up to four years to sell these properties, given the current rate of liquidation, compared to the historical average of around one and a half years.

The states that currently hold the highest number of distressed properties are Florida, Nevada, California, and Arizona. This should come as no surprise since these states were hardest hit when the housing market initially imploded. Still, New York, New Jersey, and Illinois also continue to face challenges. For instance, at current sales rates, it could take up to 10 years to fully clear the shadow inventory in the New York metropolitan area.

In the case of the banks, there are various issues and concerns regarding these properties. Some banks already own a large number of repossessed homes. Meanwhile, some foreclosure processes are being delayed as mortgages are modified to help homeowners retain their residences. This is lengthening the time it takes for some of these homes to come on the market. If these measures prove unsuccessful, though, there is a high risk of re-default. By extending the foreclosure process the banks are also able keep these loans on their balance sheets at full value, thereby postponing loss recognition.  In addition, the foreclosure process has been plagued by improper documentation, which is creating a further backlog. What’s more, if the banks were to unload a large portion of their inventories on the market it would likely depress prices further, weaken an already shaking housing market, and possibly lead to a second round of defaults and foreclosures.

Homeowners are also dealing with many dilemmas. One of the major problems in this depressed housing market is that currently close to 14 million borrowers owe more on their mortgages than their properties are worth. By being in negative equity, they face the choice of trying to hold onto their homes until there is a recovery in prices or walking away from their investments to cut their losses.  For those that have been affected by the labor market and remain unemployed, walking away may be their only option. Those who are capable of holding onto their residences until the market begins to stabilize may, at that point, look to sell and wind up flooding the market with more properties, thereby creating another round of pricing pressures.

Government intervention plans through the Home Affordable Modification Program and Short Refinance Program, among others, were implemented to ease the burden of distressed homeowners. The effectiveness of these strategies, in terms of protecting homeowners and fostering a smooth rebound in the housing sector, has so far been minimal. Furthermore, a problem that has arisen is that some homeowners, who likely have experienced a serious deterioration in their credit scores, find it more appealing to stop making mortgage payments and live “for free” on their properties than to continue paying on an underwater mortgage. In fact, it is sometimes in the best interest of the banks to let the owner remain on the property and upkeep the residence, rather than have it become vacant after being repossessed.

The complications that the current amount of homes in the shadow inventory, when unloaded, will likely create on the housing market could potentially derail a near-term recovery. From an investment standpoint, we believe that mortgage insurers still hold a high degree of risk over the next few years. For instance, MGIC Investment (MTG) has been operating in the red for the past four years, and management has not given any clear indication as to when the company will return to profitability. Additionally, the balance sheets of banks with large inventories of distressed properties will likely be under a great deal of strain, especially when losses related to these homes have to be eventually written down.  These losses would hurt their bottom lines and, in turn, probably cause downward pressure on their stock prices. Some of the banks that fit this profile are Bank of America (BAC - Free Bank of America Stock Report), Zions Bancorporation (ZION), and Regions Financial (RF).  All told, we think the risks inherent in these stocks make them unsuitable investment options for conservative portfolios and those that may be interested ought to approach with a certain level of caution.

At the time of this article’s writing, the author had a position in Bank of America.