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Tuesday, August 14, 2012

House Prices and a Foreclosure Supply Shock

by Calculated Risk on 8/14/2012 12:25:00 PM

Those making the argument for further house price declines usually start with “shadow inventory”. Although there is no formal definition of “shadow inventory” it usually includes 1) some properties with homeowners who are current on their mortgages, but have negative equity in their homes, and 2) properties not listed for sale, but where the homeowner is seriously delinquent on their mortgage or already in the foreclosure process.

This can lead to some pretty scary numbers being bandied about. As an example, CoreLogic recently reported that “11.4 million, or 23.7 percent, of all residential properties with a mortgage were in negative equity at the end of the first quarter of 2012”. And LPS reported 1.6 million loans were 90+ days delinquent at the end of June, and another 2.1 million are in the foreclosure process.

These numbers suggest a coming “flood” of foreclosures to those arguing house prices will fall further. I think this is incorrect.

If we look at negative equity, it is a serious issue for many homeowners, but it seems unlikely they will default en masse. Recent homebuyers who have negative equity are probably less than 10% underwater. And homeowners with significant negative equity probably bought in the 2004 through 2006 period; and they’ve been paying their mortgage for 6 to 8 years – so it is unlikely they will just default without some unfortunate event (divorce, death, disease).

Probably the biggest impact on the housing market is that people with negative equity can’t sell, and this restricts supply (the opposite of the “shadow inventory” argument). For more on this, see: Zillow chief economist Stan Humphries has been discussing this: The Connection Between Negative Equity, Inventory Shortage and Increasing Home Values: Why the Bottom Won’t Be as Boring as We Expected

And I expect with the recent increase in house prices that the number of reported homeowners with negative equity will be down sharply in Q2. The HARP refinance program will help too.

A more immediate concern is the 3.7 million homeowners currently 90+ days delinquent or in the foreclosure process. Many of these properties will eventually be a distressed sale, either a foreclosure or short sale, although some will receive loan modifications. It is important to remember that some of these homes are already listed for sale (so they are included in the “visible inventory”), and there has been a significant shift by lenders from foreclosures to short sales (short sales have less of an impact on prices than foreclosures).

But here is the key: Although forecasting house prices is very complex, we can make some simplifying assumptions and think in terms of supply and demand with foreclosures being a supply shock (increased supply). It is important to remember that national prices are an aggregate of many local prices (although there are national impacts, housing markets are local). And housing prices are more complex than say commodity prices (as an example, house prices tend to be stick downwards).

Imagine a multi-year supply shock with a bell curve shape. The supply shock shifts the supply curve to the right relative to the height of the bell curve. Prices will bottom when the supply shock is at the peak, NOT when the supply shock is over.

The supply shock from foreclosures probably peaked in late 2008, with a second smaller peak in 2010. Prices didn’t bottom in 2008 because 1) prices are sticky downwards (so the bottom happens after the peak of the supply shock) and 2) fundamentals such as price-to-income and price-to-rent were still out of line.

Now fundamentals are close to normal, and any supply shock will probably be smaller than the 2008 or 2010 peaks. And this analysis assumed demand was stable. Actually there was a demand shock too (less demand) due to tighter lending, and buyer psychology (potential buyers were afraid that prices would fall further). There were few investors in 2008 when the supply shock hit – just a few individual and small group investors buying REOs. Now there are large well capitalized groups looking to buy. Of course lending standards are still tight, but as the recent Senior Loan Officer showed, demand is picking up.

The bottom line is house prices have probably bottomed, and the concern about more distressed sales coming is real – but will probably not push house prices to new post-bubble lows.

Note: For reference, back in April 2005 I argued that prices were way out of line and that speculation was the key, and that speculation could be modeled as storage, see: Housing: Speculation is the Key