Shadow inventory is making news since the S&P published it’s new report in which it seems the director Diane Westerback was quoted saying, “While our estimates for the time it will take to clear the supply of distressed homes on the market have declined after reaching a peak in mid-2008, the number has been on the rise again since fall of 2009″.

The optimal phrase being “on the rise again”…and that seems to be the sound-bite for the mainstream media.

I wanted to look deeper and see if the shadow inventory numbers are a real predictor of home prices in the future. On the surface it would certainly make sense. The arguement goes, if there is more supply in homes then homes must come down in price…supply vs. demand…Economics 101, right?

Well…not so fast.

Shadow Inventory Defined

But before we get into that let’s define what we mean by “shadow inventory”.

According to our friends at BiggerPockets blog, there are 3 possible definitions…

“Definition 1 – Foreclosed but not listed. Some analysts say the “shadow inventory” is the homes which the has bank foreclosed on but not sold. These are homes that are not on the market but owned by the bank (REOs not listed on the market).

Definition 2 – Homes in the foreclosure process as well as delinquent mortgages where foreclosure proceedings are imminent.

Definition 3 – All homes delinquent, short sales not on the market, REOs not on the market, and anything in the foreclosure process.

Definition 4 – All of the above plus modified loans (as they have a large percentage of failing anyway, pay option-arms about to be reset, and lots sitting idle with builders in trouble.”

The S&P uses a definition close to #3, so we will too for this discussion.

Shadow Inventory Vs. Home Prices

The graph below from S&P appears to demonstrate our normal expectations when it come to prices…or does it?

This graph on the most recent data on the far right shows as the months to clear the shadow inventory increases the lower the prices go. That would make Econ 101 sense…increased supply results in price depression.

But wait…if we back up to April of 2009…we see the months to clear moving sideways and yet home prices continue on a downward trend.

So what does that mean?

Well, for one thing we have to understand the difference between coorelation and causation. Just because two things happend together doesn’t necessarily mean one caused the other. In this case, everyone is terrified that shadow inventories cause lower prices. That’s the fear making all the headlines.

But what if no causation exists or what if depresssed home prices causes higher shadow inventories?

Now we are getting somewhere.

Another problem with looking at this S&P graph is that shadow inventories are leading indicator…meaning it shouldn’t have a causal relationship to home prices for at least 12 months (the average length of time to take a defaulted home back to the market) down the road if it has one at all. Only once the foreclosed home is back on the market can it impact home prices. So each point on the graph for shadow inventories should be shifted left (backward in time) 12 months to see if there is a causal relationship.

Eyeballing a few points on the graph using this idea doesn’t work consistently…

My biggest problem using this chart to concluding that shadow inventories will lead to lower home prices in the future is this chart shows inventories rising when prices climb AND when prices fall.

What?

Yep…take a close look. At the far left, inventories and prices rose together and then at the far right the relationship reverses and inventories rise when prices drop.

So we know we cannot say rising inventories will lead to price drops….there is no consistent correlation. Correlation CAN be causation, but only if it is consistent. We know it is NOT causation if we can’t even find a consisitent correlation.

So how can we explain this graph?

Maybe It’s Home Prices That Impact Shadow Inventory

What if we use the hypothesis that it is home prices driving shadow inventories instead. Does the graph make more sense with this explaination?

Let’s take a look…

As home prices rose to all time levels back in 2005-mid 2007, more folks where overburdened with higher payments and started to get behind on their mortgage. Shadow inventory grew (along with home prices) topping out at the beginning of the recession which started in December 2007.

Then in late 2007 home prices started to fall while for a short time shadow inventories grew, but only for a short time as many could sell away their mortgage obligation has the market was still in reasonably good shape. Many buyers stepped in at this time falsely believing these price drops were a buying opportunity. This bottomed out the shadow inventory in late 2008 and early 2009 plateauing there for about a year. During most of this same time, home prices continue downward.

Starting in October 2009 buyers now knew the housing market was in serious trouble and pulled back their buying. Also during this time many folks found themselves underwater on their mortgage driving them to default, so for these combined reasons, shadow inventories started to climb again.

Yep…I think that fits better.

But it still is conjecture mostly. Just because the S&P wants to put two indices on the same graph doesn’t mean we should assume a relationship of any kind. We now know that shadow inventories don’t have any correlation to home prices. But maybe the home prices don’t impact shadow inventories at all either. Maybe the recession, unemployment, or other economic indicators do instead.

I just wanted to show you the fear that shadow inventories will harm home prices is unfounded, inconsistent, and therefore unpredictable.

Good Luck!

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