The Shadow Knows

[First draft, January 10, 2010] Recently I've been reading articles documenting the increasing size of "the shadow inventory" of housing. Many articles mention that in addition to foreclosed properties, and REO's, a rapidly growing portion of the shadow inventory is represented by homes for which the home loan is in default, but on which banks are not foreclosing. Many of the articles I've read explain some reasons why banks and other Collateralized Mortgage Obligation (CMO) investors would choose not to foreclose on borrowers-in-default, but none of the articles list all of the reasons I can think of for banks and investors not foreclosing. 

The change to mark-to-market accounting for certain classes of financial assets (GAAP) has been delayed by Financial Accounting Standards Board (FASB) - with pressure from the U.S. Congress and bank lobbyists (see: So, the necessity to actually account for these bank assets' true market value is currently suspended. 

If a mortgage owner is a bank and the bank forecloses, the process for re-pricing the asset begins. And, the amount of the loss on the asset would then reduce the calculated bank reserves and force the regulators to require the bank to add more reserves. Under present market conditions this would not be a good thing for the bank, or for the U.S. Government. (Under present conditions banks which could not raise more reserve assets would be forced into FDIC receivership). And, if banks actually began to foreclose rapidly on all borrowers-in-default the calls for Government Sponsored Agency (GSA) loan insurance payoffs would further complicate the bail-out of the GSA's. Also, the demand for private mortgage insurance payoffs would put further stress on private mortgage insurers and impose additional stress on the financial system in general (and probably require private insurers to increase their required reserves). 

Another reason banks might avoid foreclosing on a borrower-in-default is that judges are becoming a bit cantankerous. Judges have begun to force loan modifications, mandate cram-downs, and in the absence of good physical documentation proving a bank or investor actually owns the loan, some judges have even awarded property to the (supposed) borrower when the loan documentation is missing, flawed or incomplete. 

It seems that the rush to originate loans, slice-and-dice loan tranches, construct CMO derivatives, track ownership, and re-register frequently traded CMO's (in the electronic registration system) led some necessary loan details, and even some complete documentation, to "go missing". So banks and investors are beginning to see foreclosure as a risky and potentially expensive option. (see: 10/24/09 NYT article by Gretchen Morgensen titled, "If Lenders Say 'The Dog Ate Your Mortgage' " at> )  

Another subtlety, as long as the bank allows the borrower-in-default to stay in the home the mortgage investor (bank or CMO investor) is not as greatly exposed to losses from theft, vandalism and gross depreciation of real estate value due to non-maintenance of the property. 

Also, by not foreclosing on borrowers-in-default the lender avoids becoming the owner of the property and thus avoids direct liability for property taxes, HOA Fees, and some of the more recently imposed municipality assessments levied against investors who now own foreclosed property (see: for another example see mosquito abatement fees in some areas of California - Indio, Palm Springs, Stockton, Mountain House, etc.)

If the "shadow inventory" came to the market all at once demand would be even further overwhelmed by supply causing even more significant price erosion.

It’s logical . . . perhaps corrupt, but logical.

Other Resources:

1. See at:

2. The Case-Shiller S&P Home Price Index is published on the last Tuesday of the month with a two month time lag in reporting for data gathering and data analysis, at:

3. Also see, YouTube video The Impact of The Delay in Implementing FAS#157 at:  

4. And, watch the YouTube video The Short Sale Conundrum - Mortgage Servicers’ Misaligned Incentives at:

5. Re: Was the strategy for delaying the pain learned during Japan's 'Lost Decade'? “Geithner worked for Kissinger Associates in Washington for three years and then joined the International Affairs division of the U.S. Treasury Department in 1988. He went on to serve as an attaché at the Embassy of the United States in Tokyo.” From Wikipedia, Timothy Geithner at:

6. Watch a brief segment of Georgetown Law Professor Adam Levitin's Congressional testimony titled, "Regulators Don't Want to Know" at:


Recovery, Twisting in the Wind

I find that, when discussing The Shadow Inventory, almost all real estate specialists, lawyers, regulators and many financial analysts can’t tie one very significant cause into the conversation.

The very significant cause that is missed is a rational explanation of why banks and other mortgage investors are so reluctant to liquidate (or renegotiate) bad investments.

Why do they hold significant amounts of mortgage investments which have little hope of being profitable (over the long term)? When a mortgage is in serious default, why don’t mortgage investors accept a ‘short sale’ - and why do they allow a property to go into the potentially higher loss alternative of foreclosure?

I believe the key to understanding why mortgage investors appear to be behaving irrationally, is to understand the implications of the delay in the implementation of Financial Accounting Standard #157 (mark-to-market accounting).(1)

To understand the implications of the delay in the implementation of FAS #157 read an article from the Wall Street Journal titled, Congress Helped Banks Defang Key Rule By Susan Pulliam & Tom McGinty | pub. 6/3/2009.(2)

 Then watch Georgetown University Law Professor, Adam Levitin’s Congressional testimony titled, Federal Regulators Don’t Want to Know . . . (3)

The point that I believe most commenters miss:

The postponement of the implementation of mark-to-market accounting (FAS 157) gives banks and other mortgage (product) investors the opportunity to delay recognition of their market losses until legal ownership of the property changes (foreclosure). Thus, for the investor, the hoped for offset of losses against future revenue is 'the gating factor’ for the liquidation of the shadow inventory.

Most mortgage investors are institutions. These institutions want to delay the recognition of, and the reporting reporting of, any losses to their investors - and to their regulators - for as long as possible.

As Professor Levitin explains in his Congressional testimony, these institutional investors hope to offset losses against income (fees and penalty revenue) over the next decade.

So, the shadow inventory seems to be a consequence of the rational ‘work-out’ in a world in which institutions can carry (and report) highly depreciated assets at (fantasy) origination value.

P.S. I believe in creative destruction.(4)

1. See Wikipedia Mark-to-Market accounting scroll to, Effect on subprime crisis and Emergency Economic Stabilization Act of 2008, at:
2. Congress Helped Banks Defang Key Rule By Susan Pulliam & Tom McGinty | pub. 6/3/2009.
3. Georgetown University Law Professor, Adam Levitin’s Congressional testimony titled, Federal Regulators Don’t Want to Know . . . at:
4. Creative Destruction (Shumpeter) see:

End Note: Even some fairly sophisticated observers can’t put the delay in the implementation of FAS 157 into its proper perspective. Why do mortgage investors prefer foreclosure over a short sale? Watch Congressman Bobby Scott (D-VA) question a panel of mortgage professionals asking, ‘Are there things in accounting principals that we need to change to get everybody to do what’s in everybody's best interests?’at:

 Then listen to Thomas Cox, of Main Attorney’s Saving Homes Project, answer Rep. Scott. Mr. Cox emphasizes a different point (the conflict of interest created by servicer fee revenue) in The Short Sale Conundrum - Misaligned Incentives of Mortgage Servicers, at: and when James Kowalski, a Florida Trial Attorney for Saving Home Project, gets his turn he moves to The MERS Mess. Mr. Kawolski explains the increase in the shadow inventory as a documentation problem rather than an accounting problem, at:

On A Clear Day . . .

 Many politicians, some federal regulators, and many vocal media commentators claim that the Community Reinvestment Act (CRA) and its regulatory evolution had nothing to do with the creation of the U.S. housing and mortgage bubble. It seems that, at some point in the near future, an objective review of the facts may require a revision of the claim that the CRA was not a significant factor in the creation of the U.S. housing and mortgage bubble.1


The Community Reinvestment Act: Its Evolution and New Challenges*

A speech by Chairman of the U.S. Federal Reserve, Ben S. Bernanke 

At the Community Affairs Research Conference, Washington, D.C.

March 30, 2007

From the third paragraph below the heading: The Evolution of The CRA

Even as these developments were occurring, extensive change was taking place in the financial services sector. During the 1980s and 1990s, technological progress significantly improved data collection and information processing, which led to the development and widespread use of credit-scoring models and the availability of generic credit history scores. Deregulation also contributed to the changes in the marketplace. Notably, the lifting of prohibitions against interstate banking was followed by an increased pace of industry consolidation. Also, the preemption of usury laws on home loans created more scope for risk-based pricing of mortgages. Securitization of affordable housing loans expanded, as did the secondary market for those loans, in part reflecting a 1992 law that required the government-sponsored enterprises, Fannie Mae and Freddie Mac, to devote a percentage of their activities to meeting affordable housing goals (HUD, 2006). A generally strong economy and lower interest rates also helped improved access to credit by lower-income households.

1. To see reasoning which strongly opposes the view that the CRA was not an influence in the creation of the bubble,see: The Financial Crisis on Trial By Peter J. Wallison - WSJ OPINION pub. December 21, 2011 at: