Shadow Inventory and how an improving US Economy begets an Improving Housing Market begets and Improving US economy begets….
FT Alphaville did a nice piece on Friday talking about shadow inventory in the United States. To sum it up:
Two things about this graph.
- Visible housing inventory is approaching a low not seen in 30 years.
- You can’t take a shadow inventory number at face value. You have to understand how it was estimated.
First a little bit about shadow inventory
I want to talk for a second about shadow inventory. I wrote this explanation about shadow inventory in Letter 23:
Laurie Goodman (who I first learned of from ftAlphaville fame) pegged shadow inventory at 11M (which is an amazing 20% of housing mortgages outstanding). Mark Fleming pegs it at 2M. Both analyts are using the same data…How is this possible? Its all in the assumptions. Shadow inventory is really just houses that are expected to go into default at some point. There is nothing particularly nefarious about the concept, even though the name suggests it is some sort of inevitable flood of housing supply. It may be, but it may not. It depends on what happens. Laurie, to come up with her 11M number, assumes a fairly large number of prime mortgage defaults, including some that are currently with LTV (loan to value) of less than 100%. Laurie also looks at 60 day past due as her “bucket” from which to extrapolate current nonperforming loans. Mark on the other hand, uses 90 day past due, and does not include currently performing prime mortgage defaults.
I did a bit of investigation and the number used in the above graph is the CoreLogic number, which is the lowball Mark Fleming estimate from the above quote. According to CalculatedRisk that number is comprised as follows:
Of the 1.6 million properties currently in the shadow inventory, 770,000 units are seriously delinquent (2.5-months’ supply), 430,000 are in some stage of foreclosure (1.4-months’ supply) and 370,000 are already in REO (1.2-months’ supply).
The thing about the shadow inventory is that if what you see is what you get, then we are almost through the worst of it. Looking at the above categories that comprise the shadow inventory estimate, they total about 1.6M homes. If there was a little bit of confidence in the housing market, and you began to see sales returning to pre-crisis and pre-boom levels, you would run through those homes quite quickly.
As well, it must be kept in mind that the month-of-supply number is assuming a continuation of a level of sales that is a historically low level. Rising sales would help eliminate shadow inventory and real inventory much more quickly than the monthsof-supply number might suggest.
The most basic point here is that shadow inventory is not an inevitable houses-on-the-market number like visible inventory is. Shadow inventory is a “houses that are likely to go on the market” number where the definition of “likely” is a function of whether those home owners have jobs, how low interest rates are, whether the refinancing market is liquid enough to let home owners with high interest rate mortgages refinance to low interest rate mortgages, and probably most ambiguously, what homeowner think about the future prospects of the housing market.
Laurie Goodman and her firm Amherst Securities have some of the most pessimistic numbers on shadow inventory. She does an excellent job describing the methodology they use at her firm on this conference call. Amherst ends up with the following estimate of shadow inventory:
This is a huge number. Much bigger than the 1.6M number that CoreLogic is using. If Goodman is right then we are years and years away from a housing recovery.
But lets go through this. Amherst uses 60 days past due to define nonperforming loans. Reperforming loans are loans that were in default before but aren’t now. MTM LTV means mark to market loan to value, so a 120 MTM LTV is basically saying that the loan is worth 120% what the house is worth.
I would say that you can make vastly different assumptions about how many loans in each of these categories will default depending on whether you assume the housing market is improving or not.
Somewhat paradoxically the true amount of shadow inventory is going to be determined by the perception of just how much overhang exists in the housing market. To put that more bluntly, would you walk away from your house right now if you saw the housing market turning up?
You would be a lot less inclined to I think.
And all of this brings us to the US economy
I have two graphs here to prove my point.
When I started dumping stocks and raisigng cash in the late summer and earlier fall it was partially because of my uncertainty about Europe. But it was also partly because of my concern that the US economy was slowing down again. The big reason for my concern was that the ECRI leading index was falling again. I am reluctant to be too invested in stocks when this indicator is dropping. Once it starts to drop, I’m not all that sure that anyone knows when its going to stop. It could stop and turn around relatively quickly, suggesting a soft patch in the economy, or it could fall precipitously, indicating a sustained move back into recession.
The move down ended at the end of the last year, and the last few weeks the uptrend has shown itself to be persistant. Such persistance must be noted.
The second graph is simply jobless claims. Jobless claims are the single best indicator of the health of the economy. You simply can’t deny that claims are heading down, and that the trend down is accelerating.
Growth in an economy builds on itself. Growth begets growth. Taking it back to the housing market, I think that these early signs of true growth in jobs could begin to snowball into a housing market. Jobs beget stabilizing housing prices which begets greater housing activity, which begets rising prices, which begets falling inventories (and non-materializing shadow inventories), which begets the need to build new homes which begets more jobs. And so on.
Economies as large as the US economy do not turn on a dime. But when they turn a lot of the viscious cycles that had amplified the downturn become virtuous cycles that amplify the move up. I am of the mind that we may be in the process of making such a turn right now.