The Rate of Foreclosures and The Shadow Inventory (Part II)

Today I noticed a recent MSN Real Estate section article titled, Foreclosure Filings Fall – But Not in All States.(1) After reading the article I began to wonder . . . .

I wondered:
Does fewer foreclosure notices being filed mean there are actually that many fewer mortgage borrowers who are, or are becoming, ‘in default’ of their obligation to pay their mortgage?

Does fewer foreclosure notices being filed mean that the foreclosure process is (temporarily) becoming even slower than it has been in the past? Does it mean that the homes of mortgage borrowers who are “underwater” and have decided to use the ‘strategic default’ strategy are not becoming part of the shadow inventory?(2) Does it mean that borrowers who have fallen on hard economic circumstances are not continuing to squat in the homes they financed with the easy mortgages they were able to get when economic conditions seemed better? Are such borrowers still squatting, biding their time and saving money, until the foreclosure notice comes and the marshal forces them out of the home? Does fewer foreclosures notices being filed mean that defaulted squatters will have even longer to save money (by not paying their mortgages) before the foreclosure notice is filed and marshal forces them to leave the home in which they are squatting?

Is it possible that filing foreclosure notices has slowed because of seasonal factors? Home purchases normally decline significantly over the holidays (during the Thanksgiving and Christmas Holidays and past the New Years Holiday). If you held the mortgage on a defaulted residence would you want that residence vacant for three or four months until the Spring home buying season begins. Is it possible that the large mortgage servicers and investors [like the Government’s GSA’s, large banks and public and private pension plans] are concerned about the public relations ‘fallout’ from continuing foreclosures, at a high rate, during the holiday season? Is it possible that mortgage lenders are delaying foreclosures so they can digest their past losses on foreclosures, and hopefully offset future losses on foreclosures against future investment revenue from other asset classes and from fee income? [Are defaulted, but not yet foreclosed homes, still “the pig in python”? (see note below)]

It seems that filing foreclosure notices is an activity which the holders of the mortgage investment can control, or ‘time’ - depending on a number of factors some of which can benefit them. As, the number and the speed of foreclosure filings varies, watch very closely for changes in the shadow inventory.

Footnotes:

1. Foreclosure Filings Fall – But Not in All States By Teresa (Real Estate) at MSN - Pub. October 11, 2012, at: http://realestate.msn.com/blogs/listedblogpost.aspx?post=89cc9dfd-19e4-48c2-b...

2. For a definition of the shadow inventory see the third paragraph of the October 9, 2012 article, CoreLogic Reports Shadow Inventory Continues to Decline in July at: http://www.corelogic.com/about-us/news/corelogic-reports-shadow-inventory-continues-to-decline-in-july-2012.aspx 

CoreLogic estimates the current stock of properties in the shadow inventory, also known as pending supply, by calculating the number of properties that are seriously delinquent, in foreclosure and held as real estate owned (REO) by mortgage servicers but not currently listed on multiple listing services (MLSs). Roll rates are the transition rates of loans from one state of performance to the next. Beginning with this report, cure rates are factored in as well to capture the rise in foreclosure timelines and further enhance the accuracy of the shadow inventory analysis. Transition rates of “delinquency to foreclosure” and “foreclosure to REO” are used to identify the currently distressed non-listed properties most likely to become REO properties. Properties that are not yet delinquent but may become delinquent in the future are not included in the estimate of the current shadow inventory. Shadow inventory is typically not included in the official metrics of unsold inventory.

NOTE: The pig in the python, see:

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: http://online.wsj.com/article/SB124396078596677535.html). 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> http://www.nytimes.com/2009/10/25/business/economy/25gret.html )  

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: http://www.dlapiper.com/miami-dade_foreclosure_ordinances/ 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 CoreLogic.com at: http://www.corelogic.com/search.aspx?q=shadow+inventory

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: http://www.standardandpoors.com/indices/sp-case-shiller-home-price-indices/en...

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: http://en.wikipedia.org/wiki/Timothy_Geithner

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

 

Fraud at the GSE's?

I commented on an interesting article published September 14, 2012 in the Wall Street Journal, How Greenspan Misread the Risks at Fannie and Freddie. It’s an article based upon an excerpt (written by James Hagerty) from his new book The Fateful History of Fannie Mae: New Deal Birth to Mortgage Crisis Fall By James R. Hagerty.

My Comment:

In December of 2011 the SEC filed lawsuits against several former executives of Fannie Mae and Freddie Mac. One of the allegations in both of the two lawsuits is that former executives of Fannie and Freddie mis-categorized mortgage loans that were being bought by Fannie and Freddie and that they failed to inform investors and Fannie and Freddie’s regulator [The Office of Federal Housing Enterprise Oversight] of the true number (percentage and value) of Sub-Prime and Alt-A loans they purchased.

So, it’s not that shocking that most people who believed what Fannie and Freddie were telling them didn’t know of the significant default risk.

Only people like Michael Burry(2) Laurence Fink(3) John Paulson(4) and perhaps Stanford Kurland(5) who actually studied (or were aware of) the progressively diminishing mortgage qualification standards as the bubble formed, and who studied (or were aware of) the actual mortgage borrower income statistics, were prescient enough to become alarmed about Fannie and Freddie’s exposure to default risk.

Based upon what Fannie and Freddie were claiming as their mortgage loan quality, It should be no surprise that Alan Greenspan, John McCain, George W. Bush, Treasury Secretary, John Snow and the Office of Federal Housing Enterprise Oversight [OFEO] were more concerned about the impact of credit rate risk and accounting fraud at Fannie Mae and Freddie Mac than they seem to have been about default risk.(6) 

Footnotes:

(1) Reference SEC Website SEC CHARGES FORMER FANNIE MAE AND FREDDIE MAC EXECUTIVES WITH SECURITIES FRAUD.  

(2) Reference, Betting on the Blind Side By Michael Lewis – pub. Vanity Fair Magazine | April 2010. 

(3) Reference, Inside the Trillionaires Club at BlackRock pub. Forbes Magazine August 17, 2009. From the article: 

LESSON 2: When investments get complex, do your homework: 

. . . In late 2006 the company developed a model that put a lower, more realistic number on the incomes subprime borrowers were claiming on their "no doc" loans. The projections were shocking: BlackRock figured that when the loans reset to their new, higher rates in a couple of years, most borrowers would be spending more than half their real incomes on mortgage payments. Foreseeing an avalanche of defaults, BlackRock dumped subprime bonds in early 2007 when the prices were still lofty.

(4) See, John Paulson, Trader Made Billions on Sub-Prime By Gregory Zuckerman pub. Wall Street Journal January 15, 2008. 

(5) See, Stanford Kurland - Former Countrywide No.2 Sees Opportunity in Troubled Mortgages By Matthew Padilla Orange County Register - June 10, 2008.   From the article:  

Q. How did this venture come about?

A. I was somewhat in a state of retirement. I left Countrywide in 2006 after 27 years. From the sidelines, I was watching the mortgage market meltdown and was in communication with associates of mine over what it was going to take to improve or revitalize the mortgage market. Wall Street firms were reaching out to me on whether I had an interest in participating with them. I got a call from the chairman of BlackRock, Laurence Fink, who asked if I would meet a group of executives who were talking about how to address issues in the mortgage market, and they were working with another company (Highfields Capital Management).
I was very receptive to talking to Larry Fink. We had grown up together and have been friends since grade school days.

Q. Where did you and Mr. Fink grow up?

A. We grew up in Van Nuys. That’s the valley. 

(6) See, YouTube video-clip, Timeline: George Bush, John McCain Warn Democrats of Housing Crisis, 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)

Footnotes:
1. See Wikipedia Mark-to-Market accounting scroll to, Effect on subprime crisis and Emergency Economic Stabilization Act of 2008, at: http://en.wikipedia.org/wiki/Mark-to-market_accounting
2. Congress Helped Banks Defang Key Rule By Susan Pulliam & Tom McGinty | pub. 6/3/2009. http://online.wsj.com/article/SB124396078596677535.html
3. Georgetown University Law Professor, Adam Levitin’s Congressional testimony titled, Federal Regulators Don’t Want to Know . . . at: http://youtu.be/ibgdgl0PoBw
4. Creative Destruction (Shumpeter) see: http://en.wikipedia.org/wiki/Creative_destruction

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:

The Undisclosed Inventory of Homes

My comment on the article, Foreclosure Machines Still Running on ‘Low’  By Robbie Whelan in The Wall Street Journal [Developments Blog] – pub. July 31, 2012 at: http://blogs.wsj.com/developments/2012/07/31/foreclosure-machines-still-running-on-low/?blog_id=36&post_id=21215

The shadow inventory and the large inventory of bank ‘Real Estate Owned’ (REO’s) is a phenomenon which I believe has been caused to a significant extent by the decision to delay the implementation of FAS #157 [commonly known as ‘fair value accounting’ or ‘mark-to-market accounting’].

The delay in the implementation of mark-to-market accounting allows mortgage investors to report (on books and records) the value of their mortgage investments at the investment’s origination value rather than requiring these assets be valued at an estimate of current market value. See article, Congress Helped Banks Defang Key Rule By Susan Pulliam & Tom McGinty - pub. Wall Street Journal June 3, 2009 | at: http://online.wsj.com/article_email/SB124396078596677535-lMyQjAxMTIyNDMzMTkzNjEwWj.html?mod=wsj_valettop_email

For further insight into the implications, and one of the likely consequences of the delay of mark-to-market accounting watch a brief video-clip of a portion of Georgetown University Law Professor, Adam Levitin's U.S. Congressional testimony titled, Federal Regulators Don't Want to Know at:

The shadow inventory and bank REO's (not under current listing contracts) represent an historically significant supply of housing which in many ways is not transparent or adequately disclosed, and therefore is not fully-factored into the ‘market's pricing” of homes (supply and demand).