I, personally, have been very confused about this whole notion of “shadow inventory” that the banks have supposedly been “holding back.” I’ve heard, for the past few years, even, that the “floodgates are going to open” and all of this distressed inventory will rush to the market! Just the thought of it is enough to scare anyone, whether you’re thinking about selling now or in ten years. The potential damage that millions of distressed properties can do on home values is staggering.

Here’s a good blog from Keeping Current Matters (or KCM) that addresses this issues, and clarifies it a little bit:

Shedding Some Light on the Issue of Shadow Inventory

by The KCM Crew on November 17, 2010

There appears to be some confusion regarding the amount of shadow inventory that currently exists and the impact it will continue to have on the real estate market. Today, we want to bring some clarity to both of these issues.

First, let’s define shadow inventory because part of the confusion is in differing definitions. Originally, the term ‘shadow inventory’ was used by some to define a supposed ‘secret’ inventory; mysteriously hidden by banks from their investors and the general public. This definition caused banks to come forward and announce that they were not holding a ‘secret’ stash of foreclosures.

Those announcements were misinterpreted by some to mean there was no backlog of distressed properties. That is not what the banks said. There definitely are millions of distressed properties that have been and will continue to be placed on the market. The banks were just explaining that the number and process is totally transparent.

What actually is ‘shadow inventory’?
The most common definition of shadow inventory is given by Standard and Poor’s:

Outstanding properties that are (or were recently) 90 days or more delinquent on mortgage payments, in foreclosure, or real estate owned (REO)—that haven’t yet hit the market.

Let’s look at a graph from Calculated Risk showing that the inventory of foreclosures Fannie, Freddie and FHA currently hold is up 24% in the last quarter:

This does not include the inventories held in the private sector.

Also, there are millions of homeowners that have fallen behind on their mortgage payments. Currently, less than two percent of those who fall behind 90 days will ever make up the difference. Over 98% will become a distressed property in the future.

How long will it take to ‘clear’ this inventory?
The banks are being very cautious in the way they are releasing this inventory. If they release too many too quickly, it will have a major detrimental impact on existing home prices. If they release too few, it will retard the housing recovery which will not fully occur until this inventory is cleared.

The best analogy I have heard was from Buzz MacIntosh from MacIntosh Realtors in Maryland. He explained that the shadow inventory is like a lingering storm. If it rains too hard, there will be flooding. However, we must be willing to accept some rain or the clouds will never clear.

Estimates of how long it will take for this storm to clear range from 40 to 44 months. Housing Wire recently reported:

The shadow inventory of delinquent loans, foreclosures, and REOs stands at 7 million homes, which would take the market more than 40 months to clear, more than three years, according to Fitch Ratings.

What impact will it have in 2011?
Moody’s Anaytics, in an article by Andres Carbacho-Burgos, reported:

While U.S. housing fundamentals have certainly improved since 2008, the shadow of rising foreclosures still looms over the market and is the strongest reason why house prices will fall again in 2011. More than 2 million homes remain in some stage of foreclosure, according to RealtyTrac, and although this number has declined in the last three months, it is likely to rise again in 2011. The annual total of foreclosures, short sales, and deeds in lieu is forecast to peak at 2 million in the next year as well.

Standard & Poor’s analysts think home prices will drop between 7% and 10% in 2011. According to Housing Wire, S&P credit analyst Erkan Erturk said;

Prices will continue to be pressed down as long as the market works through a backlog of distressed properties that remains elevated.

Bottom Line                                                                                                                                                      A ‘shadow inventory’ does in fact exist and it will have an impact on the housing market for some time to come. The banks must clear this inventory but are trying to do it systematically so as to have the least negative effect on home prices.