US Shadow Inventory Threatens Housing Market Stability

The S&P / Case-Schiller Home Price Index report released earlier today showed that home prices increased again in the 20 cities surveyed in November. Overall, the index increased 0.2 percent in November, after a 0.3 percent increase in October and many are seeing this as a sign that the US housing market is on the mend. It is important to note however, that even with the recent results, the index is still down 5.3 percent from November 2008.

Despite these encouraging gains, there is no question that the market remains highly fragile and susceptible to disruptions that could quickly reverse the recent improvements. At the top of the list of things that could potentially derail the housing market, is the so-called “shadow” inventory.

The Shadow Inventory

The shadow inventory refers to properties currently in the foreclosure process, as well as delinquent mortgages where foreclosure proceedings are imminent. As the covert-sounding name for these REO properties (that is, Real Estate-Owned) suggests, it is difficult to get a read on the exact number of properties now held by financial institutions, but an estimate from the Amherst Securities Group last fall suggested that there are more than 7 million REO properties.

To put some perspective around this number, consider that there were a total of 4,913,000 existing homes sold in the US in 2008. For 2009, the number rose slightly to 5,156,000 and marked the first increase in annual existing home sales since 2005. Using the 2009 result as a guide, it would take almost a year and a half to sell just the properties contained in the shadow inventory!

But there are many more properties than those in the shadow inventory alone that are expected to be offered for sale in the coming year. Homeowners who struggled to hold on to their homes during the worst of the financial crisis, now see an opportunity to recover some of their losses as prices climb. Not to be outdone, the first wave of baby boomers – many of whom held off selling the family home in favor of smaller, more manageable homes when prices fell – now hope that the time is right for them to recover more of their home’s equity to cushion their retirement years.

Effect Increasing Inventory Could Have on Housing Market

It seems counter-intuitive to suggest that the flood of property listings expected to come to market later this year could result in an increase in house prices, but this is one scenario some experts suggest could materialize. The argument goes like this: repossessed properties and homeowners stretched to the limit will place listings that will still be bargain-priced compared to pre-2006 prices. The demand for these deals will continue to grow as the US economy recovers, and this will ultimately lead to an on-going resurgence in housing prices.

I understand the rationale at work here, but this outcome relies on a strong recovery that continues to gain in intensity through to the end of the year and well into 2011. Granted, the International Money Fund (IMF) did recently up its 2010 prediction for growth from 1.5 percent to 2.7 percent, but this revision comes with a caveat. The IMF cautions that unemployment is expected to remain in the range of 10 percent until the end of the year at least, as will the tight credit conditions and neither of these outcomes bodes well for home sales.

Worse still, the IMF suggests that most of the growth will actually be short-lived, resulting mostly from companies restocking their inventories that were cut during the recession, as well as the lingering effect of the government’s stimulus spending.

For these reasons, I think the more likely scenario is that there will be a demand for properties initially, and as long as buyers feel they are able to purchase homes at below market values, demand will remain strong. However, given the size of the shadow inventory alone, supply will quickly outpace demand and inevitably, prices will fall thereby threatening a short-term rebound in the housing market.

* Home sales statistics from realtor.com website

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