One of the great economic success stories of 2012 was that the housing market finally found a bottom, and even began to show signs of a nascent recovery. But even as positive data on the real estate market began to trickle in early last year, not everyone was convinced. The main reason for skepticism were millions of homes that had not yet hit the market, but probably would soon — either because they were already in foreclosure or because the homeowners were so far behind on payments that foreclosures were imminent. These properties, which last year were estimated to range anywhere from 3 million to 10 million in number, were dubbed the “shadow inventory” of homes.
The reason the shadow inventory was thought to be bad news for the housing market was that when these homes finally did go up for sale, they would overwhelm the demand for housing, which had slowed in recent years due to the poor economy and sluggish population growth. But a recent report from analytics firm CoreLogic says that the shadow inventory as of October 2012 has fallen to 2.3 million, a 12.3% drop year-over-year. In other words, this catalog of homes has been reduced significantly without the detrimental effect on nationwide home prices that some had feared. So what happened, and why has the dreaded shadow inventory not yet sunk the convalescent U.S. housing market? I asked Sam Khater, Deputy Chief Economist at CoreLogic, and he outlined three key reasons:
Investors Got in on the Game
The housing recovery was prevented for so long in part because of tight credit standards and because so many homeowners owed more on their mortgages than their homes were worth. This left many homeowners unable to take advantage of increasingly cheap prices. But by 2012, home prices had fell so far that it became lucrative for investors — either investment vehicles like real estate investment trusts or individual investors looking to earn extra income as landlords — to snap up real estate at historically low prices. Khater says the speed and enthusiasm with which investors bought these properties was a bit of a surprise, and one of the main reasons why the market was able to work off a significant chunk of shadow inventory without it depressing home prices.
Lenders Ramped Up Principal Forgiveness
When a homeowner cannot repay his mortgage, mortgage lenders often end up losing a lot of money even after they repossesses and resell the home. Homes sold after foreclosure sell for a deep discount, and going through foreclosure proceedings is very costly for banks as they must continue to pay taxes and upkeep costs while the process unfolds. So modifying a delinquent loan so the borrowers can remain in the home, even if it means forgiving principal, can sometimes make sense for all parties involved.
The problem is that the securitization of home loans, whereby loans are pooled and sliced up into different payment “tranches,” or bundles, made it so that there wasn’t one specific investor who could decide to modify a loan. And the fight over who would bear the losses when a mortgage was modified prevented much modification from happening at all.
Beginning with the $25 billion mortgage settlement between the nation’s largest mortgage servicers and states attorneys general, however, the tide began to shift a bit. Banks have been forced, because of the terms of that settlement, to engage in principal-reducing mortgage modifications, which have helped keep homeowners out of foreclosure and, thereby, their homes off the market. According to a recent report from the OCC the share of loan modifications made by servicers in the third quarter of 2012 that include principal reduction have risen 110.6% when compared to the similar period in 2011.
Many Homeowners Remain Underwater
Even with the improving housing market, many homeowners remain underwater. Paradoxically, this has buttressed the housing market of late, as it keeps these homeowners from putting their property on the market. These homeowners being locked out of the market, combined with avid interest from investors in cheap residential real estate, has led to the amount of homes for sale being historically very low. And when supply is restrained, prices go up. As prices rise, more homeowners will get out from their underwater mortgages. “This dynamic will unlock some borrowers, but it won’t lead to a flood of new homes on the market,” Khater says. “It’ll be more of a slight opening of the spigot.”
All this goes to show that predicting the movement of large, complex markets like housing can be difficult even for experts who make a living doing just that. A year ago, many smart people took a look at the inventory waiting on the sidelines, and couldn’t imagine the market being able to absorb it. The fact that lenders are more aggressively modifying mortgages and a new investor class has stepped up to take advantage of cheap prices shows that even the savviest of analysts can be caught off guard by new trends.