The “Shadow” knows.

Back in July, I mentioned the growing phenomenon of the so-called “shadow” inventory, which are the properties that by all rights should have been foreclosed on a long time ago, but where the banks are, for reasons of their own, not taking any action. The mainstream media has caught up, and there are two recent articles about shadow inventory that you should know about. One is in the Wall Street Journal (subscription required), the other is in The Atlantic Monthly, which helpfully quotes at length from the original Wall Street Journal article. As the Journal puts it,

“there were 217,000 loans in July where the borrower hadn’t made a payment in at least a year but the lender hadn’t begun the foreclosure process. In other words, 17% of home mortgages that are at least 12 months overdue aren’t in foreclosure, up from 8% a year earlier.”

What is the cause of shadow inventory? It does not appear to be exactly clear what is motivating the banks’ lack of action on these properties. There may be differing reasons: a lack of personnel qualified to process the foreclosures or loan renegotiation; an unwillingness to add a flood of foreclosures to a brutalized real estate market (which might trigger other foreclosures as homeowners’ equity evaporates); or, perhaps the most sinister reason of all — the banks are simply hiding their toxic assets. While it is one thing to have a nonperforming loan on your books, it is another thing entirely to have to write down the entire loss that a foreclosure will entail. Once this loss is realized, bank regulators may require a concomitant increase in reserves, at a time when cash is in short supply. The end result could be bank failure, and we’ve seen plenty of these already this year.

What does this mean for the real estate investor? One possibility is that the banks will be able to carry a lot of this inventory until the broader market recovers, then start selling it off in in an orderly process. The other possibility is that the housing crash might not be over until all of REO inventory is cleaned out, whether or not the bank acknowledges it as an REO. What will happen? Only the shadow knows.