Shadow Inventory: What Is It? How Did It Affect the Economy?

How the Shadow Inventory Made Selling Your House Impossible

Bank owned shadow inventory
••• The shadow inventory was homes somewhere in the pipeline of foreclosure. Credit: Justin Sullivan/Getty Images

Definition: The shadow inventory counts the houses that are in some stage of foreclosure, but have not yet reached the market.  It must be added to unsold homes that were listed as for sale to get an accurate picture of housing supply. In 2010, there were two homes in foreclosure for each one for sale, according to Capital Economics.

CoreLogic defined the shadow inventory more precisely. It counted the homes that were 90 days or more delinquent, in foreclosure, and owned by lenders.

It didn't include homes that were behind on payments, but the bank hadn't begun foreclosure procedures.

That's why Capital Economics' estimate was so much higher. In October 2010, CoreLogic estimated there were 2 million homes, or nine months of supply. This uncertainty about the real number created uncertainty.

This shadow inventory depressed housing prices for anywhere from one to three years. Investors were reluctant to buy homes, knowing the shadow inventory was hanging out there. They waited until these foreclosed homes were absorbed, and prices had a better chance of rising sooner.

The shadow inventory was in addition to the real inventory of unsold homes. That was around 4 million homes as of September 2011. At that rate of sales, it was an 8.5 month supply. Another 250,000 homes were added to the shadow inventory each month.

What Should Have Been Done to Reduce the Shadow Inventory?

Unfortunately, government programs didn't make a dent in the shadow inventory.

A two-year glut of unsold homes and shadow inventory kept housing prices flat for years. The Federal government could have done a whole lot more to address this problem.

Why did the government virtually ignore this looming threat? It may not have known what to do. PIMCO fund manager Bill Gross suggested using government funds to turn all 5-7% mortgages into 4% mortgages.

He said this would have lifted housing prices 5-10%.

Most initiatives didn't stem the foreclosure tidal wave. The HARP (Homeowner Affordable Refinance Program) was introduced in April 2009. It allowed the 2 million credit-worthy homeowners who were upside-down in their homes to refinance with lower rates. Unfortunately, only 810,00 homeowners were helped. Why? Banks cherry-picked the best applicants.

The Treasury Department launched Making Homes Affordable in 2009. It worked with banks to help owners modify their loans before they went into foreclosure. Unfortunately, banks only modified the payments, not the principal. Most homeowners owed twice as much on their mortgage as the home was worth. They realized it was pointless to struggle to make payments with little hope of a decent return on their investment.

The Federal Reserve had a consumer help website. It also had one to help community leaders assess and address problem areas. The Fed kept interest rates low. It bought toxic debt from banks. Those programs never addressed the root of the foreclosure problem for homeowners.

Amazingly enough, some legislators suggested things that would only worsen the problem. Some suggested abolishing Fannie Mae and Freddie Mac.

That would have been a disaster. Their loan guarantees are required before a bank will even think about lending. Before the financial crisis, Fannie and Freddie guaranteed 50% of all mortgages. Afterward, it rose to 90%.

The Dodd-Frank Reform Act required a 20% down payment on all mortgages. According to the National Association of Realtors, only 40% of home buyers at that time could even afford a 20% down payment.

Shadow Inventory Timeline

  • September 2011 - "Home Sales 7% Higher Than Last Year." Banks started working through the foreclosure pipeline, boosting home sales but lowering prices.
  • July 2011 - "One Million Foreclosures Pushed Out to 2012." Foreclosures continue to back up, thanks to delays in bank processing. It took 318 days for banks to foreclose in the second quarter, 41 days longer than a year ago.
  • May 2011 - "Home Prices Keep Falling." Sixteen million homeowners (28%) were upside-down in their mortgages, adding to the shadow inventory and causing home prices to fall 1% a month.
  • December 2010 - "Foreclosure Probe Adding to Shadow Inventory." The foreclosure rate was down 24% from the prior year. That should have been great news, but wasn't. It was because banks were slowing down their foreclosure process in response to a Federal government probe on their hurried foreclosure practices. Homeowners continued to fall behind on their payments. That just added to the 1.8 million homes in the shadow inventory.
  • "Economic Growth in Fourth Quarter 2010 was 3.6%."  What held it back? A sluggish housing market. After most recessions, housing is usually the first sector of the economy to recover. New home construction creates jobs. Construction jobs were sorely lacking in this recovery.
  • September 2010 - "Foreclosures Are 35% of All Sales."  This is lower than a year ago, thanks to banks slowing down the foreclosure process in response to Federal investigations.
  • July 2010 - "There Are Two Homes in Foreclosure for Every One for Sale." A study by Capital Economics says there are 7.8 million homes in the shadow inventory. That's much worse than CoreLogic's estimate of fewer than 2 million homes.
  • April 2010 - "Option ARM Loans Worsen Shadow Inventory." These loans only made up 2% of all mortgages nationwide, but 60% in California. They have penalties for refinancing, among other dangers
  • October 2009 - "Shadow Inventory Looming." As early as October 2009, Barron's magazine warned about the shadow inventory, which would take 15 months to work through even back then.