Foreclosure Glut: Is 'Shadow Inventory' Really a Threat?

June 7, 2010 — -- Every once in a while, the term "shadow inventory" makes it into the business headlines. Invariably, stories warn of a looming flood of foreclosures that will drag the housing market down as soon as homeowners begin to feel optimistic again.

But what is shadow inventory -- and is it really such a big threat?

Different experts have different definitions. Some only include homes that have already been repossessed by banks and are awaiting distressed sales. Others include those whose owners are long-overdue on mortgage payments, while others still count homes whose owners would like to sell but are waiting for conditions to improve.

8 Million More Foreclosures May Be Waiting

"The definition of shadow inventory has gotten out of control," says Rick Sharga, senior vice president at RealtyTrac, an online market for distressed homes.

As a result, estimates of homes in the shadows vary widely between 2 million and 8 million. By comparison, approximately 5.5 million homes are expected to change hands this year, of which about a third are in some kind of distress.

High estimates usually include include repossessed homes that have not yet been listed for sale, homes that have been moved from the delinquent bucket and into foreclosure, and homes that are more than 60 days delinquent.

"Theoretically you could say up to 7 million homes are in the pipeline, but not all of them will go into the market and if even if they do, not all of them will hit at once," says Sharga. Given the current pace of sales, Sharga believes shadow inventory could be cleared by the end of 2013, at which point the housing market can begin a real recovery.

Shadow Inventory Can Be Lethal

The problem with shadow inventory is that it does not simply represent additional supply. It's supply of the worst kind: distressed homes that are often in hard-hit regions, often in a state of disrepair. Homes in foreclosure have more power to drag down real estate prices and keep them depressed for years to come.

"If you can buy a cheap foreclosed home next door to a normal home, many people will choose to buy the discounted home," says Celia Chen, housing analyst at Moody's Economy.com. She estimates that 4.6 million homes are currently waiting in the shadows, almost a whole year's worth of housing supply.

Shadow Inventory Stuck In Limbo

Like many other analysts, Chen believes we still have a long way to go before real estate prices begin recovering. Some expect a recovery to begin in the middle of next year, others don't see it coming for several more years.

There are many reasons that shadow inventory is so difficult to gauge.

For one thing, financial institutions that own distressed mortgages are not saying exactly how many homes they hold. Firms have generally been releasing their supply of distressed homes slowly into the market for fear of crushing prices.

Another problem is that nobody knows exactly how many homes will make it out of the government's "Home Affordable Modification Program." Chen estimates that only 45 percent of the 1.2 million loans that are aiming for a modification will actually succeed, while the rest will likely end up in foreclosure.

While these numbers certainly are cause for concern, the good news is that this shadow inventory is unlikely to cause a shock to the system similar to the initial crash.

No Nuclear Event in Housing

"Much as during the arms building between the U.S. and the Soviet Union, neither one ever launched a nuclear attack for fear of causing complete destruction," says RealtyTrac's Sharga. "You're not going to see a nuclear event happen in the housing market either."

Esmael Adibi, economics professor at Chapman University says shadow inventory is actually a good thing bcause it means that financial institutions – primarily lenders and investors who own the delinquent mortgages – are holding on to the inventory instead of dumping it into the market.

Adibi says financial institutions are not only holding on to their inventory in order to avoid crushing the market, but also because they believe they might get a better deal once prices have recovered slightly.

"Can you imagine if all those homes ended up in the market now?" he says. "Things would be much worse."