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:

 

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).

Zombie Accounting and The Shadow Inventory

I recently watched a U.S. House of Representatives Judiciary Committee Hearing on C-SPAN. The hearing, which was held on December 15, 2010, was titled “Mortgage Services and Foreclosure Practices”.1 The testimony and the questions and answers in the hearing provided a significant amount of interesting information about the processes, and the legal and practical issues surrounding the mortgage servicing industry, and the Mortgage Electronic Registration System (MERS).

Because I followed the history of Congress’s involvement in pressuring the Financial Accounting Standards Board (FASB) to delay the implementation of FAS #157 in early 2009.2 I found a question, which was asked by Congressman Bobby Scott (D. VA) troubling.

At approximately 1 hour 36 minutes into the hearing Congressman Scott asked, in essence, if there was anything in “accounting standards” that might provide incentives for mortgage investors and mortgage servicers not to agree to short sales and to prefer alternatives that might be less advantageous for all parties.

I was surprised by the question because of Congress’ significant role in pressuring the FASB for a delay in FAS #157 and I was also bit surprised that none of the witnesses could directly answer the question - from an accounting standards perspective. In general, the witnesses only discussed the mis-alignment of incentives, where mortgage pooling and servicing agreements provide ongoing revenue for servicers when a short sale is not agreed to and a foreclosure is delayed.3

Footnotes: 
1. The December 15, 2010 House Judiciary Committee “Mortgage Services and Foreclosure Practices” hearing may be seen at:  http://www.c-spanvideo.org/program/297095-1
2. See a Wall Street Journal article titled, Congress Helped Banks Defang Key Rule By Susan Pulliam and Tom McGinty pub. 6/3/2009 at: http://online.wsj.com/article/SB124396078596677535.html Also see, For Your Reading Pleasure By Jack Ciesielski pub. in the Analyst’s Accounting Observer 2/25/2010 at: http://www.accountingobserver.com/PublicBlog/tabid/54/EntryId/12583/For-Your-Reading-Pleasure.aspx
3. Under the typical mortgage securitization “Pooling and Servicing Agreements” mortgage investors agree to pay mortgage servicers fees for arranging: home inspections, arranging broker ‘opinion of value’, preparing and filing documents, general documentation, notifications, forced insurance fees, and etc.