Shadow inventory and price declines

By March 14, 2010Housing Market

While I’ve previously written about the confusion around the term shadow inventory, it is now increasingly used to refer to properties that are delinquent, or in foreclosure, rather than unlisted bank owned homes. Standard & Poors recently posted a well written analysis of shadow inventory, and has jumped to the conclusion it will likely “undo U.S housing price gains”.

They estimate that the current backlog of distressed mortgages will take just under 3 years to clear. They call that estimate conservative… I think it is likely optimistic given that delinquency rates are still climbing. Still it is a reasonable guess. Here in CA we have one million homeowners who are already delinquent, and we seem to be clearing about 25-30k a month based on foreclosures and short sales (which are the only “solutions” that are actually clearing the distress by eliminating negative equity). Divide one million by 30k, and you come to the same 33 month conclusion they reach.

Another interesting part of the report deals with recently cured loans… those no longer delinquent, primarily due to loan modifications. They suggest that these should be included in calculations of shadow inventory, as they have had a nearly 70 percent rate of recidivism – in other words, most become delinquent again because the loan mod failed to address the core problem of negative equity. Seems like a reasonable conclusion to me.

Where I take some issue with Standard & Poors assessment is there conclusion that liquidation will lead to lower housing prices. They come to this conclusion based on the simple idea that an increase in supply will lower prices. There is some truth in that notion. For example we certainly have seen some pricing strength recently due to efforts to slow foreclosures which have clearly constrained supply, while at the same time demand has been stimulated with low interest rates and tax credits.

But this simple supply/demand theory of housing prices fails to adequately consider the fact that housing is highly leveraged, and that price is primarily a function of income and loan terms, and only secondarily supply and demand. Worse, this over-simplistic supply/demand model has led many to believe that foreclosures cause price declines, when in fact it is exactly the opposite… price declines cause foreclosure.

Note that the foreclosure crisis started in earnest in late 2006, however, price declines did not start until lenders removed the ridiculous loan products that enabled people to over pay in August of 2007. At that point we had a precipitous drop in price… not due to foreclosures, but instead due to the fact that people simply couldn’t afford the prices reached during the bubble without those loan products.

Foreclosures and housing supply grew rapidly during the price correction, but those who think the correction was due to either these foreclosures or the growing supply are terribly mistaken. Instead it was simply a correction back to reasonable prices, that buyers could afford based on their incomes and the more traditional loan products that remained available.

Unfortunately the belief that foreclosures and supply caused those declines remains all too common as yet again evidenced by the conclusion of this report. It is a belief that is delaying our recovery as government works to artificially constrain supply by slowing foreclosures, leaving homeowners stranded in prisons of debt, and buyers with little available inventory to choose from.

The reality is that there is a bottom to housing prices. People need a place to live and are willing to spend a certain portion of their income on housing to do so. Investors need to find returns, and there is a point where buying homes as an investment make sense. In many parts of California we’ve returned to those prices levels. And in those areas that have already corrected withholding supply won’t return prices to prior levels… people simply can’t afford it. And contrary to Standard & Poors’ analysis increasing supply is just as unlikely to cause further price declines… people need a place to live, and investors are too desperate for reasonable returns.

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  • Robert says:


    Great points. I think there has long been confusion between “demand” and “credible demand”. Sorry, I haven’t come up with a nifty term but you touched on it. Demand simply being all the people who _want_ a home and what I’ve called “credible demand” as the number who can actually afford a home (that they’d be willing to live in).

    This is where the lax vs strict lending critera make all the difference.

    From the front lines in San Diego, my observation is that limiting the housing supply is in fact driving up prices. However, it should be noted that here I am referring _only_ to the entry level housing market, where a conforming loan will get you into the house. That being said, no, prices are not rising so fast we will get to bubble prices any time soon.

    • Sean O'Toole says:

      Credible demand sounds “nifty” to me. 🙂

      I certainly don’t disagree that supply and demand play a role. Your example of constrained supply at the low end causing an increase in prices is a clear example of the fact that it does play a role. I’d simply argue that supply/demand is a distant second to base affordability (ability to pay a given price at a given income based on given loan terms).

      Bottom line, is that no matter how tightly supply is constrained we can’t get back to 2006 prices without doubling incomes or going pack to 1% teaser rates. 🙂

      • Shelley says:

        I would love to see statistics showing purchase price and average income per zip code. I think this would be a very good indicator of “who” can afford the prices. Regardless of the amount of homes that are trickled out or held back, if homes are not priced to match the economic environment, they will sit there. This can see this very clearly on the MLS for homes above say $600.000.

  • David Brian says:


    Thanks for all of the great data and insight you provide on your sites.

    In the last sentence of this post you say that ‘investors are too desperate for reasonable returns’. Can you provide some clarification on that statement? I am not certain I understand who you are referring to as the ‘investors’ and I am really lost on the ‘too desperate for reasonable returns’ part.

    Thanks a bunch!

    • Sean O'Toole says:

      Hi David – When the fed puts in place a zero interest rate policy (ZIRP) like we are presently under it forces investors to take greater risks then they normally would to find reasonable returns on their capital. Until and unless that policy changes I think we’ll find that housing has a reasonable floor in the 5-12% return on investment range depending on the quality of the housing. One exception, though unlikely in CA, would be areas where you have a net loss of population – in those areas only population growth or a bulldozer can restore home prices.

  • Tracy King says:

    I completely agree with you that the decline of prices is causing foreclosures. And it’s affecting many more than those that bought with the crazy loan products. I have talked to many people who bought with 20% down or had refinanced with 80% loan to value, but the downturn in the economy first wiped out their equity and then cost them their jobs, making them unable to continue to make payments that they had formerly been able to afford. If they can’t manage to negotiate a loan modification (and does anyone know anyone who has?), they are fodder for the foreclosure mill.
    But in our Northeast Los Angeles and San Gabriel valley markets, the inventory has been so low that any decent property that is well priced is going in multiple offers. Smart REO owners drip their foreclosures into the market and get better prices than they would have if they had dumped them on the market in a pile as everyone keeps saying they will. Why would they? They are not that stupid.
    Also, I see a number of properties in Eagle Rock that are scheduled to go to Trustee’s Sale and they have been on and off the schedule for the last couple of years. Some of these people might be able to sell for enough to pay off their mortgage if they can hang on a few more years. Or sell short in this more favorable environment. At this rate, they might pull it off.

  • […] no responses Sean O’Toole is the creator of Foreclosure Radar and just published a very interesting article on his blog. Here in CA we have one million homeowners who are already delinquent, and we seem to […]

  • Great Statistics. California has all kinds of micro-markets. Bottom line is that in some communities the home prices are at or close to the cost to build point. With these communities being close to business cities I think that these are key places to invest. The prices are not going to fall much more and when jobs return so will the commuters and the home prices.

  • […] about the possibility of a Costa Mesa short sale shadow? Sean O’Toole with Foreclosure Radar points out that there is still a heavy backlog of distressed mortgages. If these homes are unable to […]

  • Darius Wells says:

    The home was just so overpriced in California, that most of the home buyers had to get a interest only loan just to be able to afford the payments. California is not going to stop seeing big foreclosure until the lenders or the government help with principal balance reduction. A Loan Modification will only be a short time resolution, which homeowners will still re default in the future.

  • Richard says:


    You make many good points again! When I do valuations (BPOs) for lenders I split up the market into three seperate slices including normal Equity Sales, REO and Short Sales. In my market there are very limited Equity and REO sales and these prices are going UP. Short Sales are abundant, often don’t close and are discounted to attract buyers.

    I haven’t seen any reports on prices seperated out like this. Short Sale levels have more negative impact on prices as REO if not more!

    A lack of REO and normal inventory and a high level of Short Sale activity is driving prices right now and no one has figured that out. We Listing Brokers continue to see REO sell in a week with multiple offers for more than full price!


  • The most recent report from NAR is that the shadow inventory is roughly 2.4 million which might be low in my opinion as there are over 130 mil. households in the U.S. If this data is correct it might not be as horrible as it is only roughly 2% of the countys homes.

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