Did you know that the only pressure on lenders to dispose of their real estate owned comes from shareholders?

Irvine Home Address … 15 MORRO BAY Irvine, CA 92602
Resale Home Price …… $1,629,000

{book1}

So sure
So sure you are
Nothing can
Touch you now
I need to know
Did you think of me
But you’re forgettng me now
Slow down
Don’t be so
Eager to let me go
Realise it could change you
It could change your mind

Repetition — Blur

Today I briefly want to again Revisit Option ARMs, and I want to address a common misperception about REO; lenders do not have to sell REO due to regulatory pressure. Shareholders may dissuade lenders from becoming real estate investors, but the banking regulators will not.

The Option ARM Kingpins: Who Holds the Elusive Option
ARMs?

$189 Billion Securitized and Outstanding and big Three of Wells
Fargo, JP Morgan, and Bank of America Playing with Time.

There have been many charts … and much of the confusion is around a few key points:

-1. Banks have been circumspect given the actual number of option ARMs

-2. Many option ARMs are in California (roughly 60 percent of the market)

-3. Many of those behind on payments are now simply not paying their mortgage but banks are not moving

It is hard to quantify the above data since this is something banks
would like to hide. Nearly 60 percent of all current outstanding
option ARMs are in the hard hit state of California.
As many of you know, the median price of a home in California has
fallen by 50 percent. The peak in home prices was reached in 2007, the
last year option ARMs were made in mass. Since that time, option ARMs
were merely ticking financial bombs.

…

But what if homeowners balk? Many in California are strategically
defaulting. In many cases, unless their mortgage meets with market
rents many will walk away. Also, the California unemployment and
underemployment rate is at 23 percent so no amount of modifying can
help out with a loss of income.

So let us sum up the option ARM market:

$750 billion in option ARMs were originated between 2004 and 2007.
The top 10 option ARM originators cornered over 60 percent of the
market. Of these, many are now part of the too big to fail banks.
We know that $189 billion is still securitized in investor portfolios
while many billions are still on the banks books (i.e., $107 billion
with Wells Fargo and $50 billion with Chase). The bottom line is the
option ARM issue is still here and we will be contending with this for
the next couple of years.

That doesn’t sound very good, does it?

From yesterday’s discussion about Shadow Inventory, matt138, said, “Shadow Shadow inventory – the people who are currently thinking, “why the hell am I still paying if nobody else is?” I did some calculations and my result was: A LOT.”

What I find interesting is how much of the Option ARM problem has already been resolved (probably through foreclosure). If $750B was issued, and only $200B remains, only 20%-25% of the Option ARM problem remains — at least in the form of Option ARMs. Many of these original borrowers already went through short sale, foreclosure or walked away. The Option ARMs didn’t go away due to market sale because the homedebtors were all underwater, and these loans did not go away through successful loan modification because cure rates are very low.

The good news is 75% of the Option ARM holders appear to have defaulted early. The bad news is most of the homes of these borrowers will end up as REO sold on the open market, it is only a matter of when. This problem is going to be stretched out as long as possible, and the abundance of overhead supply will prevent appreciation from saving the market for many years.

Lender’s Options for REO

The lenders I have spoken with are genuinely concerned about the auditors forcing them to reclassify loans. Many lenders are not properly categorizing their loans for accounting purposes — the still have it on their books as if it is a good loan and the borrower is making their payments. Many, many non-performing residential loans are still classified as performing while lenders have the shield of government loan modification programs. The reality is many of these loans are not performing, they are never going to, and lenders are not being forced to recognize this fact until their balance sheet ratios support it.

Regulators are not concerned with what a lender does with the REO it picks up through the foreclosure process as long as the losses are accurately accounted for — in theory. Once the REO department gets a property, the only pressure they get to sell property comes from through management from shareholders.

Shareholder Pressure

People who invest in banks are investing in a business that writes loans and carries loans on its balance sheet. If a balance sheet becomes polluted in the eyes of investors with real estate assets, it starts to look less like a bank and more like a real estate investment trust or a hedge fund. When banks cease to be banks, investors bail out and stock prices crumble — at least that is the belief of bankers, so the management does not want to hold real estate. Also, REO is lingering evidence of prior poor lending practices, and nobody wants to keep that around.

The implication for the market is simple, there will be no forced dump of REO instigated by bank regulators. That isn’t to say we don’t have a huge pig to send through the snake, but it can be digested in smaller pieces rather than one massive chunk. We may (probably will) see a cartel arrangement evolve, but the large amount of supply and the competition to dispose of it will serve as a drag on prices until the inventory is exhausted. In some markets that will take decades.

Direct from an Asset Manager

As part of my work, I go to Building Industry Association meetings on a regular basis. As a courtesy to them, I am keeping my sources anonymous, but should any of you wish to attend a BIA meeting, you can see and here these people yourself. The meetings are open to the public for a fee.

At a recent meeting I listened to asset managers from two major West Coast banks. I asked one of these asset managers to detail his banks policy toward REO based on market conditions. He said that in markets where they do not see recovery in a longer-term horizon (think Lancaster), they may sell at reduced prices to clean up the mess; however, if they do see the market recovering in a reasonable time, they will hold the property, and perhaps even rent it out while values improved. In short, the REO departments of these banks are empowered to act as responsible asset managers trying to obtain the greatest recovery for the bank. This also means there will be no massive inventory dump forced by a government regulator.

Each bank will evaluate its own financial circumstances, its exposure to the market and other factors and pursue a policy of maximizing recovery while disposing of these assets. Certain banks will dump in some markets and hold in others. It will be the chaotic collapse of a cartel with much volatility, and most likely slowly declining prices for several years as lenders slowly release their inventory to obtain price recovery.

Blue skies are not here yet.

Irvine Home Address … 15 MORRO BAY Irvine, CA 92602

Resale Home Price … $1,629,000

Income Requirement ……. $337,684
Downpayment Needed … $325,800
20% Down Conventional

Home Purchase Price … $791,875 ???
Home Purchase Date …. 3/28/2001

Net Gain (Loss) ………. $739,385
Percent Change ………. 105.7%
Annual Appreciation … 8.3%

Mortgage Interest Rate ………. 5.01%
Monthly Mortgage Payment … $7,004
Monthly Cash Outlays ………… $9,040
Monthly Cost of Ownership … $6,540

Property Details for 15 MORRO BAY Irvine, CA 92602

Beds 4
Baths 4 full 1 part baths
Size 4,464 sq ft
($365 / sq ft)
Lot Size 8,285 sq ft
Year Built 2000
Days on Market 4
Listing Updated 12/10/2009
MLS Number P713549
Property Type Single Family, Residential
Community Northpark
Tract Cmbr

**Bring your checkbook & RUN…DONT WALK!** Drop-Dead GORGEOUS & *PRICED TO STEAL!* PREMIUM GREENBELT Location, Serene PRIVACY & Tranquil PARK VIEWS! Rare *OVERSIZED LOT* w/Huge ENTERTAINERS BACKYARD! Location! LOCATION! **THIS HOME SURPASSES EVERY HOUSE IN THIS PRICE RANGE!** Must See to Believe! Exquisite Architecture w/Romatic Archways, Dramatic 10-Ft Ceilings, Walls of Windows, Splendor of Natural Light & Inviting French Doors that Welcome Outdoor Living & Entertaining! Spacious Open Design offers 4 Bedrooms w/Bath en suite (Including Main Floor BR & BA) & BONUS ROOM (Optional 5th BR) plus Office, Exercise Rm/Study, & Elegant Formal Living & Dining. Huge Gourmet Kitchen w/Chefs Island Opens to Charming Breakfast Nook & Generous Family Room w/access to Sprawling Backyard & Custom BBQ. An Entertainers Delight! Master w/Retreat, Fireplace & Huge Closet plus Generous secondary bedrooms w/walk-in closets & tranquil park views! EVERY ATTENTION TO DETAIL! *ACT FAST!* Only ONE like this!!!

This description is awful on every level. It contains (1) RANDOM CAPS LOCK, (2) three exclamation points, (3) random asterisks, (4) numerous cliches, (5) over-the-top writing, (6) Intermittent Caps, (7) cheap techniques to create urgency, (8) and a general lack of substance. If the nonsense were strpped from the description, the number of words cuts in half and the reader is spared needless distraction.

My data records do not show the original purchase price, but it does show me the original first mortgage. I assumed the mortgage was 80% of the purchase price. That may not be correct.

As borrowers, the owner’s of today’s featured property did not add to their mortgage. Kudos. That is a rare accomplishment worthy of recognition.

Since I first estimated Shadow Inventory others have been trying to figure out how big the problem really is. Today’s featured property is an example of Shadow Inventory finally coming to light.

Irvine Home Address … 12 FOXHILL Irvine, CA 92604
Resale Home Price …… $594,900

{book1}

If you ever feel like something’s missing
Things you’ll never understand,
Little white shadows sparkle and glisten,
Part of a system, a plan

White Shadows — Coldplay

One of the carryovers of the Great Housing Bubble zeitgeist is the high level of suspicion about the people who are gaming the system to their advantage. The general public has little or no perception of the Titanic forces competing for their money, and discussions about sinister elements at the Federal Reserve sounds like conspiracy-theory nonsense to some.

Similarly, discussions of “Shadow Inventory” sound like the ravings of madmen. But those of us paying careful attention to the numbers know we have a problem. These ravings are the voice of reason staring at the chaotic struggle of greed and pointing out the economic ripples. These ripples are growing to a tsunami of foreclosed properties.

I am utterly astonished at the level of Government intervention, but we will see more. IMO, if you look far enough down the road, losses to the FHA — losses directly absorbed by the US Taxpayer — will finally call an end to government market props. Pressure is already building to increase downpayment requirements and eliminate tax subsidies. FHA is subprime, and everyone knows it. Will this batch walk away when they go underwater? Probably.

Shadow Inventory Revisited

In Shadow Inventory Orange County, I explored one method of calculating or estimating the number of
truly distressed property owners in Orange County. Since then, others
have written on the same subject including a new blog I am introducing today.

New Blog

I like to recognize excellence when I see it, and I found a new blog through Patrick.net called Finance my Money. The “About” doesn’t say much about the author, and the blog has only been around since August of 2009, but I found two excellent posts there:

California Notice of Defaults hit Record in 2009: Approximately 476,000 Notice of Defaults but Foreclosures Fell. HAMP Most Active in California. Approximately 5,900 Permanent HAMP Mods in California.

California Housing Inventory Mystery: 206,000 Homes on MLS but is the Real Inventory 412,000 or closer to 618,000?

The first post confirms, “California is at the center of the foreclosure wave. Of the 306,000
foreclosure filings in November 23 percent hit in California. You
cannot talk about housing distress without looking at the state of
California. The California housing market will be in a slump for many
years and there are a variety of reasons why California housing will see no recovery in 2010.
One of the most important leading indicators of housing distress is
notice of defaults. With so much talk about housing recovering the
data is showing that 2009 will set a record in terms of NODs filed in
California. 476,000 notice of defaults will be filed by the end of the
year setting a pace of over 1,300 NODs filed per day in 2009.”

In Shadow Inventory Orange County, I discussed that one method of leaving Shadow Inventory is by curing the loan, generally with a loan modification. Since loan modifications are billed as a housing market panacea, it is worth seeing how these programs have done:

Many have argued that HAMP will help many of these loans. California is the largest HAMP state:

Yet the above number is a misnomer. In fact, nationwide only a handful of modifications have become permanent:

Of the 759,000 HAMP trials started only 4 percent have become
permanent. This number is abysmal. In fact, if we take the 148,000
trial mods in California we can assume that only 5,920 have made it to
the permanent stage. We had 476,000 notice of defaults filed in 2009!
The HAMP is merely a delay of reality.

The cure rate was 6.6% back in September. It isn’t improving.

In defense of the HAMP program, the cure rates will get better because there are people who have made 1 or 2 months payments that will cure when they get to three months, so there is a lag in the reporting. The headlines will ignore the lag two months from now when the real cure rate is revealed.

For what it is worth, I guestimate cure rates will be between 10% and 15% as currently defined; however, there will be pressure to lower the bar. Did you notice three months is considered permanent? Three years maybe, but three months of consecutive payments doesn’t seem like much to ask. Despite how low this bar is, it could go lower. In fact, this program could fail to produce a single loan that survived to a market sale or payoff, and by their standards it would be a success.

We pick up the Shadow Inventory issue again in the second post:

So even though notice of defaults for 2009 are reaching the 475,000
mark actual defaults for the year are going at a pace of 230,000. In
other words, there is a major gap in the data. This isn’t because
loans are curing either. Recent cure rates are under 5% and for
California, they are even lower. So most of those 475,000 notice of
defaults are going to become additional inventory at some point. In
fact, how many of those 475,000 homes are even listed in the 206,000
current inventory? That is the major question and brings up the shadow
inventory trends.

A recent report from Amherst Mortgage Insight tackled this question:

There is another method of calculating shadow inventory. It’s out there, and the lenders don’t really want you to know it.

Irvine Home Address … 12 FOXHILL Irvine, CA 92604

Resale Home Price … $594,900

Income Requirement ……. $123,320
Downpayment Needed … $118,980
20% Down Conventional

Home Purchase Price … $852,000
Home Purchase Date …. 10/17/2005

Net Gain (Loss) ………. $(292,794)
Percent Change ………. -30.2%
Annual Appreciation … -8.4%

Mortgage Interest Rate ………. 5.01%
Monthly Mortgage Payment … $2,558
Monthly Cash Outlays ………… $3,160
Monthly Cost of Ownership … $2,510

Property Details for 12 FOXHILL Irvine, CA 92604

Beds 4
Baths 2 full 1 part baths
Size 2,522 sq ft
($236 / sq ft)
Lot Size 5,400 sq ft
Year Built 1975
Days on Market 4
Listing Updated 12/10/2009
MLS Number F1827782
Property Type Single Family, Residential
Community El Camino Real
Tract Dc
According to the listing agent, this listing is a bank owned (foreclosed) property.
REO.CASH ONLY! Open bright & airy. Landscaped backyard. Close to parks, schools, malls and freeways. 4 Bed + 2.5 Baths.

This was a loan issued by Nationpoint; it didn’t perform very well. The owner of this property paid $852,000 on 10/17/2005. He used a $680,000 first mortgage, a $170,000 second mortgage, and a $2,000 downpayment. On 6/20/2006 he got $10,000 out of the property. About a year later, he stopped paying the mortgage.

Foreclosure Record
Recording Date: 03/05/2008
Document Type: Notice of Sale (aka Notice of Trustee’s Sale)

Foreclosure Record
Recording Date: 11/30/2007
Document Type: Notice of Default

Foreclosure Record
Recording Date: 11/30/2007
Document Type: Notice of Rescission

Foreclosure Record
Recording Date: 11/14/2007
Document Type: Notice of Default

This property was purchased on 7/15/2008 for $620,034 by DEUTSCHE BANK NATIONAL TRUST CO, ; FIRST FRANKLIN MORTGAGE LOAN TRUST 2006.

Shadow inventory coming to light?

There is not much chance of this property selling for asking price as comps are much higher. This property will be bid up well over asking — not because Fundamental Value says so — it is overpriced at listing price on that basis, but if you look at what buyers are able to finance today, comps for this house are much higher than $600,000.