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:

 

Jingle Mail

Michael Burry, M.D. was one of the earliest investment fund managers to recognize the problems in the housing and mortgage market. Dr. Burry’s story is very well told in a chapter of the book The Big Short By Michael Lewis, and also in an article which was published in Vanity Fair Magazine titled Betting on the Blind Side, also written by Michael Lewis1 . This morning I was doing some searching and reading on the mortgage market and some of the key-players in the market. In that activity, I came upon a link to Dr. Burry’s published Scion Capital Investment Newsletters. As I was browsing through the letters, I discovered this very interesting comment (prediction) from Dr. Burry’s Second Quarter of 2003 Letter to Investors2. I thought you might like to see this comment from the Scion 2Q 2003 Letter to Investors:
When home prices begin to fall, a natural level of weak support may develop around a loan-to-value ratio of one. That is, when equity in a home approaches zero, the homeowner ought to become reluctant to sell. History suggests any such strategy should prove foolhardy. Trends in housing tend to be long and headstrong, and hence not easily resisted…The development of significantly negative home equity among the same homeowners that also comprise the world’s most voracious consumers would likely trigger several economic problems…banks would become reluctant to lend to home buyers. The effect would be to contract the credit available to would-be homeowners and therefore severely undercut the main late-cycle driver of demand…These problems would compound the worsening domestic employment situation, further reducing demand for residential housing and thereby producing the requisite positive feedback loop that historically has allowed burgeoning asset deflation to accelerate. As the real estate deflation wears on, it would not be unreasonable to expect that unemployment-induced income shocks mix in toxic fashion with the comparatively high mobility tolerance of the United States citizenry, motivating homeowners to start sending their keys to the bank in ever-increasing numbers. Many banks taking possession of increasing amounts of real estate will ultimately fail themselves. A catharsis could then take shape, and home prices would leg down yet again. After much pain both despair and disgust will settle in, and a bottom would begin to form.

-Scion 2Q 2003 Letter to Investors
Footnotes:
1. Betting on the Blind Side By Michael Lewis – published in Vanity Fare Magazine | April 2010 at> http://www.vanityfair.com/business/features/2010/04/wall-street-excerpt-201004

2. Scion Capital 2Q Letter to Investors at> http://www.scioncapital.com/PDFs/Scion%202008%201Q.pdf