Monday, January 24, 2011

1 Million Home Foreclosures: Just the Beginning

The recent numbers released by RealtyTrac1 are startling. The fact that 1 million homes were foreclosed upon in 2010 is clearly quite troubling. However, I believe that the full impact of the supply glut of foreclosed houses on the market is still yet to come. The reason is that there is a huge “shadow inventory” of homes that are either in the foreclosure pipeline or are now held on the banks’ balance sheets. As discussed in an article2 from, Standard and Poor’s estimates the shadow inventory by adding the number of houses whose borrowers are 90 days or more delinquent on their payments to those that are in foreclosure or are now owned by the banks. How many houses fit this description? Well, according to S&P, there are 1.7 million homes in this category, an inventory so large that based on the current rate of home sales, it apparently could take up to 44 months to work off.

Ok then; housing prices won’t rise for a few years until the excess supply is absorbed. So what? Actually, my concern is that these numbers only represent a fraction of the total foreclosures that will occur during this painful housing cycle. Specifically, the trouble lies in the number of homeowners who are underwater on their mortgages. Simply, if a person’s outstanding mortgage balance is nominally higher than the current value of the associated house, that person is deemed to be underwater or have negative equity in his or her home. Recently, there has been a back and forth between Zillow, a firm that tries to estimate the number of homes that have negative equity, and the so-called Numbers Guy, Paul Bialik, of the Wall Street Journal. As many people are undoubtebly aware, it is not uncommon to hear a talking head on venerable stations such as CNBC assert that one in four US homeowners is underwater. In fact, estimates3 that the appropriate figure was 23.2% at the end of Q3 2010. However, the article in the WSJ4 makes some valid points that suggest that such disturbing estimates may be a tad high. In response, the people at Zillow acknowledge the fallibility of their estimates but claim is that the true number is closer to 23% than it is to 15%, as Mr. Bialik suggests.

So, what does seemingly harmless argument have to do with future housing prices? Well, the important thing to consider is not necessarily the total number of homeowners who are underwater but instead by how much the balance of an individual mortgage exceeds the value of the property. For example, if a person owns a house worth $90K and has an outstanding balance of $100K, chances are the person will hesitate before exercising his put option on the house. But, what if housing prices see another large leg down? According to the most recent Case-Shiller housing data from October 20105, national housing prices have already started to double dip. Thus, given an already weak housing market, my worry is that when the shadow inventory of homes eventually comes onto the market (even if it occurs at a snail’s pace), prices will see even more weakness. Then, the fact that there are already so many homes with negative equity suggests that people will find themselves even further underwater in the near future.

What if a number of borrowers are currently at a tipping point from which a renewed decline in home prices will cause a cascade of strategic defaults? Going back to the hypothetical borrower discussed above; if the house price falls by another 10% and he is now $19K underwater, is that enough to push him over the edge? If it is, then the foreclosure pipeline will continue to increase and there will be a structural overhang that limits home price stabilization for years to come. If you were wondering why some professional investors are still so bearish on the housing market, you now know why.