Tsunami alert! Run for the hills! A brand new foreclosure wave is headed for a city near you!
The Wall Street journal published an article last week that probably got less attention than it should have, because the implications it contained are major for the housing market. According to the article by Mark Whitehouse, the inventory of unsold homes on the market now stands at 107 months. That is to say, it would take close to nine years at the current rate of sales to eliminate the backlog of foreclosed homes currently on bank balance sheets in addition to the shadow market of homes in distress and headed for repossession. Just in terms of supply and demand this promises to put a huge damper on price growth in housing for a long time ahead. There is tremendous supply and very little demand at current prices.
Over the past couple of months I have been perusing the listings of foreclosed homes at Realty Trac, the Irvine based online marketplace for foreclosed property. What I’ve seen has been shocking. There is an option on the website to view foreclosure listings in a map format, where you can look up any neighborhood you are interested in and see specific homes and what stage of foreclosure they are in. There is already a glut of homes listed for sale, but in every neighborhood I’ve looked at the number of homes for sale is dwarfed many times over by the number of homes in distress. For every house listed for sale there are at least five others around it in some state of foreclosure. The backlog of unseen inventory waiting to hit the market is of monstrous proportion. Granted, I’ve been looking at the housing market in the Los Angeles area, which is one of the areas worst hit by the effects of the real estate bubble. The view is exaggerated here. Nevertheless, while foreclosure numbers are concentrated in metro areas, the number in the Wall Street Journal article pertains to the national market. The US has nine years of housing supply, when a healthy market normally holds enough inventory for around six months of sales.
The basic foreclosure process is fairly simple to understand. There are three stages of development. The first is a state of “pre-foreclosure” that begins when three to six months of payments have been missed on a property loan. The lender orders a trustee to record a Notice of Default, commonly referred to as an NOD. The homeowner then has three months to bring the loan current and avoid repossession of the property. The rate at which homeowners are able to do this across the board is called the “cure rate.” It is important to note that the cure rate today has fallen to historic lows- very close to 0%- so just about all the properties in pre-foreclosure today will end up seized by the bank.
If a loan is not brought current in three months, a sale date is scheduled for the property. This sale is called a Trustee Sale, and typically takes place on the steps of the county courthouse. The property is auctioned off to the highest bidder, who must pay in full with cash. This method of buying properties is usually left to professional investors, as properties are sold “as-is” sight unseen with no room to negotiate contingencies, and the buyer is responsible for any liens. The opening bid price for a property at auction is set so that it covers the outstanding balance of the loan along with interest accrued and any additional fees or attorney costs. Because so many of the homes falling into foreclosure today were originally purchased at monstrously inflated prices during the housing bubble or refinanced using very overly optimistic appraisals, the opening sales bids make them overpriced even at auction. This, along with the sheer volume of homes washing up onto the courthouse steps these days is leaving most auction properties unsold at the end of the day.
When a distressed property fails to sell at auction, ownership reverts to the bank. This is the third and final stage of foreclosure. The property becomes an REO, which stands for Real Estate Owned by lender. This will be the inevitable outcome for the majority of mortgages entering delinquency today, which is very bad news for banks. The government’s loan modification programs have largely resulted in failure and have not made a dent in the number of homes ending up back on the books of lenders. Due to changes made in 2009 by the Financial Accounting Standards Board, banks have been allowed to avoid marking these assets to realistic market prices, resulting in the crisis appearing much less severe on paper than it actually is. The fact is, if those reclaimed properties were valued at what they would actually sell for on the market today instead of what they were appraised at when the banks originally issued loans on them in the midst of a housing bubble of unprecedented proportion, many banks would be rendered insolvent. They do not have enough in reserve assets to cover losses on all the bad loans coming home to them. The banks instead are presiding over an expanding flood of property that is now worth half of what it needs to be in order for them to reconcile their books and stay in business.
Despite the mark-to-make-believe accounting trickery going on these days at banks, we have seen the institutions fail in such numbers since this crisis began that the FDIC essentially ran out of money back in 2009 covering the losses. To date 307 banks have failed since 2007, with the number of banks going under in 2010 about to surpass that of last year. For better or for worse, the market has a way of finding equilibrium despite our best efforts to control it. This crisis is worsening for banks, and that further threatens the stability of the economy as a whole.
Famous investor and philanthropist Warren Buffet once said “It’s only when the tide goes out that you learn who’s been swimming naked.” As the waters of housing mania subside we are seeing more and more incidents of fraud exposed, and the situation in the foreclosure business is proving to be no exception. Legal issues coming to light recently regarding so called “robo-signers” and illegally confiscated property are expected to put a damper on the speed with which foreclosures are processed. Several of the largest banks have stopped foreclosure processing altogether until the situation is properly investigated and rectified. This will result in the temporary delay of an unknown percentage of REO properties reaching the market, which some market watchers are predicting will offer a temporary reprise from declining housing prices. Inevitably these foreclosures will be sold , however, so it is just a matter of time before the market succumbs to their influence. In addition to this, many potential buyers will most likely be wary of purchasing foreclosed property until the legal issues are worked through, which in itself will place downward pressure on the market as sales dry up. Currently, a quarter of all home sales nationwide are REO properties, with the numbers in bubble affected states like California, Nevada and Arizona coming in at fifty percent. However it plays out, a new wave of foreclosures is upon us. It may suffocate the market in a long slow flood or knock it over with a swift forceful blow, but it has arrived nonetheless and it’s already getting our toes wet. Expect to see further price depreciation ahead in housing.
The Wall Street Journal
Number of the Week: 107 Months to Clear Banks’ Housing Backlog
By Mark Whitehouse
October 30, 2010
Shadow Foreclosure Avalanche, Coming Soon to a City Near You
Keith Jurow, Ph.D
October 29, 2010
Number of Bank Failures: 2010 about to surpass 2009
October 23, 2010
FDIC To Consider Ways To Replenish Deposit Fund
Sep 18, 2009