September 13, 2011

 

Introduction 

 

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As the supply of foreclosed homes for sale increased, home prices dropped and created a negative cycle. This 

compelled homebuilders to ratchet down home production to balance supply with demand. Accordingly, single 

family housing permits dropped to under 1.4 million by 2006 and continued to freefall thereafter, reaching the 

historic low of roughly 440,000 units in 2009. Since 2007, a cumulative 2.5 million fewer homes were built relative 

to long term demand (i.e. versus a steady 1.35 million per year rate)—essentially offsetting the preceding over-

construction. In 2010, annual new home construction was just 600,000, consisting of 450,000 single family homes, 

100,000 multifamily and 50,000 manufactured homes. At present, the deficit in new home construction exists 

primarily due to depressed new household formation rates (which we will discuss later). Finally, as the preceding 

chart shows, we would note that cumulative excess housing builds (relative to estimated long-term demand) are 

currently near lows not seen since the late 1960s. If history is any guide, we expect housing construction to snap 

back fairly quickly, as it did in the early 1970s, when demand normalizes.  

Existing Homes and Shadow Inventory 

Meanwhile, we believe that existing housing inventories have peaked and excess inventory is becoming 

manageable. There are currently nine months of supply of unsold homes in the market. Much of the excess is 

regionally concentrated in areas such as Arizona, the central valley of California, Florida, Georgia and parts of the 

Midwest.  

 

 

Source: Moody’s Analytics, “Housing Hits Bottom in 2011”  

 

Not coincidentally, these regions also rank in the top 10 areas for foreclosures. Therefore, it is encouraging 

that RealtyTrac reported that foreclosure activity is off 29% for the first half of 2011. During the 2Q 2011, 

foreclosures totaled 608,000, down 11% compared to 1Q 2011 and down 32% from 2Q 2010. This is the lowest 

quarterly total since 4Q 2007 and June 2011 was the ninth straight month where foreclosure activity decreased on 

a year over year basis. We acknowledge that a portion of the decline in foreclosures is attributable to processing 

and procedural delays due to the banks’ questionable foreclosure process, otherwise known as robo-signings. 

RealtyTrac estimates that approximately one million foreclosure actions that should have taken place in 2011 will 

now occur in 2012 or later.  

One cannot overlook that there also exists an additional supply of unsold homes known as “shadow 

inventory.” Shadow inventory consists of distressed properties not currently listed on multiple listing services that 

are seriously delinquent (90 days or more), in foreclosure, or owned by lenders. According to CoreLogic, the 

shadow inventory of residential properties as of April 2011 stood at 1.7 million units. While this may seem like a lot 

of supply, it has declined from a peak of 2 million units and 8.5 months of supply and now represents a more 

manageable 5 months of supply at the current sales pace. 

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Introduction 

 

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Source: CoreLogic, June 7, 2011 

 

As we noted above, growth in existing home inventory has been constrained by processing/procedural 

delays associated with the foreclosure process. In addition, we would also highlight the potential for new supply of 

shadow inventory from homeowners who are not currently delinquent on their mortgage, but whose mortgages are 

currently underwater. According to CoreLogic data, as of 2Q 2011, 22.5% of tracked mortgaged homes or 

10.9 million homes have a mortgage that is above the current value of the property, including close to 10% of 

homes with greater than 25% negative equity.  

 

Distribution of Home Equity 

 

Source: CoreLogic, September 13, 2011 

In theory, it would appear to make financial sense for individuals to walk away from their underwater 

mortgages, but in practice this is not always the case for a number of reasons. First, there may not be a 

comparable residence to rent/purchase in an individual’s desired geographic area. Second, walking away from a 

mortgage has a number of negative long term implications including the inability to access credit in the future. 

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Introduction 

 

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Third, we would note that while appraisals were likely elevated during the housing boom, they’re likely overly 

conservative at current levels. Accordingly, it may be difficult for a homeowner to purchase a home in a desired 

location at the “appraisal” value. Additionally, it may still make financial sense to pay down an underwater mortgage 

if the home value is expected to appreciate sufficiently over time. Finally, we would not entirely dismiss emotional 

factors such as strong ties to the home as a place of memories and/or moral qualms with walking away from a 

contractual debt.  

Default Rate for Homes by Home Equity Status 

 

Source: CoreLogic, June 7, 2011 

Reflecting these factors, historical default rates for underwater mortgages are actually relatively 

modest. As illustrated in the preceding chart, according to CoreLogic, default rates have averaged between 2% 

and 12% depending on the level of negative equity. Nonetheless, we would note that even an extreme scenario in 

which 50% of the mortgages that are more than 25% upside down on their mortgages eventually become part of 

the shadow inventory, we estimate this would still represent a relatively modest 7 month overhang of additional 

inventory. 

Potential Policy Countermeasures  

Although still in an exploratory phase, the Obama administration is examining ways to pull foreclosed 

properties off the market and rent them instead. This should help alleviate some of this excess supply of foreclosed 

homes and stabilize housing prices. HUD owned about 69,000 homes at the end of April, while Fannie Mae and 

Freddie Mac owned an additional 218,000 homes at the end of March. Combined, these homes represent about 

47% of 2Q 2011 foreclosed supply.  

In addition to measures to pull foreclosed homes off the market, the Obama administration is also looking 

to broaden U.S. homeowners’ ability to refinance their mortgages. The administration has said said the plan could 

potentially free up more than $2,000 a year for each family refinancing. While the plan is not without its challenges, 

it has the potential to result in the refinancing of 2.9 million mortgages in its first year and avoid ~110,000 defaults, 

according to the Congressional Budget Office.  

Household Formation 

Household formation is a key driver of demand for residential real estate. Simply stated, households are 

residential units that shelter one or more individuals which are typically created via marriage, divorce, immigration, 

second home/vacation home purchases, or children leaving the home. Prior to the economic downturn in 2008, 

household formation had increased at a fairly steady rate. Since the 1970’s, households had typically increased by 

approximately 1%-2% per year. However this growth was significantly curtailed by the economic dislocation 

experienced in 2008 (see following chart). According to the 2009 Annual Social and Economic Supplement to the 

Current Population Survey (CPS), total U.S. households increased by only 398,000 (up 0.3%) between March 2008 

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