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   ARTICLE   |   From Scotsman Guide Residential Edition   |   May 2013

A Long Shadow Gets Shorter

Shadow inventory has been shrinking, but what lies ahead for the distressed market?

A Long Shadow Gets Shorter

It wasn’t too long ago that the words “shadow inventory” struck fear into the hearts of housing-market analysts. Many within the industry believed  that there was a massive overhang of distressed properties poised to flood the market and destroy home values, leading to yet another wave of foreclosures that would wreak havoc on an already struggling economy.

Some estimates of the shadow inventory took on extreme proportions. One veteran mortgage-market analyst pegged the shadow inventory number as possibly being more than 10 million homes, a number much higher than the next highest estimate, but one that certainly generated a fair amount of attention from the media.

Flash forward to 2013, when the industry is looking at what seems to be a genuine, sustainable housing-market recovery, and the flood of distressed homes never materialized. Is it safe to get back into the water? And whatever happened to all those houses?


There are many definitions of what comprises shadow inventory. For instance, some analysts reached their estimates of distressed homes by creating complex models that calculated how many of the millions of underwater homeowners ultimately would default versus how many homeowners would decide that they simply needed to sell their homes regardless of unfavorable market conditions, thus contributing to a glut of homes for sale. Fortunately, however, it appears that both of those assumptions were incorrect.

Perhaps a simpler and more straightforward definition of “shadow inventory” would be the following: The shadow inventory consisted of real estate owned (REO) properties that weren’t listed for sale; properties in the foreclosure process that weren’t listed for sale; and homes occupied by seriously delinquent borrowers — i.e., 60 days or more past due on their loan payments — that weren’t listed for sale.

At the peak of the foreclosure crisis, this number likely approached 6.5 million properties, a number that certainly seems substantial, even compared to the 7.2 million homes that sold during the peak year of the real estate boom. So, with no end in sight to the foreclosure tsunami and a six-and-a-half-year supply of distressed properties, housing market analysts seemingly had good reason to be concerned. For many within the industry, of even greater concern was the belief that lenders and investors simply would decide to put everything on the market at once, despite massive evidence — and logic — that suggested just the opposite would occur.

The shadow effect

However justifiable analysts’ concerns may have been, the shadow inventory’s recent history has been far less destructive than many predicted. Why has this turned out to be the case?

For one thing, it’s taken longer and longer for servicing companies to begin foreclosure proceedings on delinquent borrowers. In many cases, the formal process didn’t begin until the borrower was well over a year past due. Similarly, foreclosure processes stalled significantly. Even when a borrower was in foreclosure, for instance, it often took a year or more — especially in states such as New Jersey and New York — for the foreclosure to become finalized. Market analysts should have known that many of the homes in the shadow inventory were going to stay there for quite some time.

In addition, it made no financial sense for investors — and especially for lenders — to dump massive amounts of distressed assets on the market, accelerate their losses on the sale of those assets and simultaneously devalue the rest of the properties that they had loaned money against. With all of this in mind, what seemed much more likely to happen was a measured, relatively slow disbursement of these homes into the market at roughly the same rate as buyers might absorb them — and in fact, that’s precisely what has happened.

Finally, the one-two punch of short sales and successful loan modifications has reduced significantly the overhang of distressed properties. About 950,000 foreclosure-related sales were completed this past year, and it’s possible that this number will be surpassed in 2013 as lenders clear their books of distressed assets, and investors and homebuyers compete for limited inventory of available properties.

Similarly, loan modifications likely will continue to reduce the inventory of distressed homes. Since 2007, there have been more than 6 million loan modifications issued, with more than 1 million Home Affordable Modification Program modifications being completed, and about 5 million proprietary modifications being issued by servicers on behalf of lenders and investors.  Many of the modifications issued this past year included principal balance reductions, as the largest servicers hurried to comply with the $20 billion in write-downs they committed to as part of the National Mortgage Settlement with 49 state attorneys general. 

In short, the combination of slower foreclosure procedures, carefully managed asset disposition, and skyrocketing short sales and loan modifications has resulted in the shadow inventory shrinking. As such, the inventory simply has not had as big of an impact on market conditions as what was feared previously by many market watchers.

Looking ahead

Even with some idea of the shadow inventory’s recent history, the question remains: What do the next few years have in store? Today, many estimates peg the shadow inventory at somewhere between 3 million and 4 million properties. Simultaneously, the pipeline of new distressed inventory has slowed to a trickle; less than 2 percent of loans issued in 2011 and 2012 were non-current after 12 months, according to a recent LPS report.

Further, the market is absorbing more than 1 million distressed homes annually, according to data from the National Association of Realtors, and inventory levels of homes for sale continue to be lower than normal, meaning that properties often receive multiple offers when they’re put up for sale. Increasing home prices mean that fewer borrowers are upside down on their loans, and therefore are less at risk of going into default. Given these trends, it appears that the distressed-home inventory could be back to normal levels within the next 24 months to 30 months.

•  •  •

Although it still seems too early to proclaim that the housing market is back to full health — especially in light of unemployment, slow economic growth and rising interest rates tempering some of the more optimistic projections about the market — it appears that the housing industry has finally begun to come out from under the shadow cast by the mountain of distressed inventory. With any luck, what now lies ahead is the long, slow trek toward happier, brighter days.


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