The Infamous Shadow Inventory

The Infamous Shadow Inventory

This title sounds like I am writing about merchandise that was hijacked in Gotham City while Batman was taking his cape to the dry cleaners, but unfortunately it's not fiction. It's very real and pretty serious. Shadow inventory is the combination of bad loans sitting on lender balance sheets as well as real estate foreclosed on by lenders that have not been put back on the market. It's referred to as shadow inventory because it is not quite inventory on the market in the traditional sense of an REO listing on the multiple listing services, but it casts an ominous shadow over the market because of its potential to become such inventory. Its shadowy nature also results from the fact that it defies precise analysis and assessment because the lenders are not entirely forthcoming about how much of this stuff they have on their books.

SNL Financial estimates that the foreclosed properties portion of the shadow inventory held by lenders is approximately $41.5 billion. That's up from $36.9 billion at the end of 2009. Properties in various stages of the foreclosure process but not actually owned by the lender totals $78.6 billion which also represents an increase from last year of 9%.

If all foreclosure activity ceased today, the current shadow inventory would take 3-4 years to clear out. The long tail of the shadow inventory suggests a slow protracted recovery, but the bigger concern would be the problem of dumping. If lenders began for any reason dumping significant quantities of their REO's on the market in a short period of time they could further destabilize the market. By dumping, I mean listing massive numbers of houses on the multiple listing services simultaneously with REO listing agents. Such a flood of REO listings would cause prices to drop even further and cause ordinary listings to sit longer.

I have attended several panel discussions that included bank executives and bank economists as part of the panel. Consistently the consensus has been that lenders will not dump their shadow inventory on the market because it would erode the stability of their remaining portfolio even more. That clearly would be the rational position but we have seen some pretty irrational things happen in this market. As of right now it appears that the shadow inventory is building. Hopefully, the lenders can continue to absorb it without having to take drastic measures, as they have done up to this point. Otherwise we may be pointing a searchlight rigged with a symbol of a bat into the evening sky.