Shadow Inventory to Keep REO Supply Elevated for Several Years

An estimated 4.1 million borrowers – nearly 1 in 10 – are in the process of foreclosure or are more than 90 days delinquent and heading that way soon. Their homes makeup what’s been termed the “shadow inventory” – a pent up supply of REO properties that could soon hit the market, driving home prices down further and perhaps cause another wave of defaults.

Guhan Venkatu, an economist at the Federal Reserve Bank of Cleveland, has released a paper outlining three different scenarios of how the current shadow inventory could translate into actual inventory, as properties move through the foreclosure process to become REOs.

Venkatu’s research found that even under the most benign assumptions, the stock of REO properties “is likely to remain elevated for the next several years.”

Until recently, the number of borrowers in foreclosure or more than 90 days delinquent was fairly stable, since the number of loans entering these categories was generally being balanced by the number of loans leaving them, Venkatu explains. But that balance has been disrupted by lengthened foreclosure timelines as servicers have stepped up loss mitigation efforts.

Prior to 2009, about 8 percent of loans transitioned from foreclosure to REO status every month. By 2010, that proportion has been cut in half – a development Venkatu called “worrisome” for the nation’s housing markets.

Venkatu says movement from foreclosure to REO “is critical” given market dynamics and he suggests that the degree of damage resulting from the industry’s ominous shadow inventory will depend on how many repossessed homes become available for sale, when they become available, and how long they remain on the market.

Various factors may influence the speed at which homes with loans in or near foreclosure are reclaimed and turned back out onto the market.

But Venkatu says given current economic forecasts, households will be under financial distress through 2013, resulting in elevated REO levels for years to come and threatening to derail housing’s already tenuous recovery.

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