Shadow Inventory and the Financial Crisis

The financial crisis may not be over despite some sectors indicating we have reached bottom -- especially due to the ominous factor of the real estate "shadow inventory" still looming on the horizon -- something the banking industry seems to be ignoring.

In order to understand what may affect our future, we look to the recent past where it all began.

How did the financial crisis start? One expert, James Ballard, St. Louis Federal Reserve President and CEO, compares the failure of "financial engineering" to the failure of asbestos.

In a document from the Federal Reserve Bank of Saint Louis, MO, entitled "Origins of the Financial Crisis: What Happened?" Ballard equates the mortgage loans sold just prior to the financial crisis to the highly toxic properties of asbestos.

Asbestos is still around in many homes today. This toxic substance becomes dangerous when it gets in the air after being disturbed, and then taken in by breathing the toxic air. "Authorities believe there is no safe level of exposure," according to the California Department of Consumer Affairs.

When you sell a home in California you must advise a resident of the potential for asbestos in a home. The CA Gov. Guide to Asbestos advises consumers to, "not disturb any material you think may contain asbestos unless you have to. Removal of the material is usually the last alternative." When it is removed, it is very costly and must be done by a licensed expert. The individual homeowner bears the cost of removal, or suffers the potential deadly effect of the toxin.

With this comparison in mind, Ballard goes on to paint a picture of where we are now.

"It's really that as a market, as a nation, as a world, we didn't really understand what was going on here. So once this failure of financial engineering occurred, now you've got toxic assets spread all around the globe and it's just a big mess that has to be, has to be, fixed. That's in the broadest terms how I like to think about where this crisis came from."

These toxic loans have yet to be flushed out of our financial system. According to Keith Jurow , Ph.D., who has been researching and writing about the housing market -- especially about the issues that are "frequently overlooked or ignored by the media," -- wrote about the "Shadow Inventory Avalance Coming Soon".

The final tally of homes that are counted in this pending shadow inventory is, "6.97 million residences which are almost certainly going to be thrown onto the resale market as distressed properties at some point in the not-too-distant future. This massive number of homes will put enormous downward pressure on sale prices," according to Jurow.

The danger of asbestos exposure lingers because it has never been completely cleaned up. The mess from the mortgage industry also still remains. Unlike asbestos, however, the wave of shadow inventory will not lay silently dormant for decades. Instead, it will likely be released as an economic toxin in the coming years.

We can no longer claim "we didn't really understand what was going". We now understand the problem and the effects. Now the question remains, how will we clean it up?

"And it just had to be cleaned up, and that's the way it was. So that was a big shock and a big problem, and I think that's how you should think about the failure of financial engineering," concludes Ballard.

The financial crisis due to the failure of the mortgage industry silently continues as banks sit on toxic loans and Americans are stuck in homes worth much less than they owe. Their mortgages often bearing higher interest rates than the current prevailing rate they could receive purchasing a new home for half the price.

"During the worst of the financial crisis, the Feds relieved American banks of troubled investments, many linked to mortgages, to give the banks room to make new loans," according to Peter S. Goodman, of the New York Times.

"The big question is, who's going to swallow the losses," asks Nobel-laureate economist Joseph Stiglitz. "It should be the banks, but they don't want to. We're likely to be in paralysis for years if they prevail."

There is one potential solution that has yet to be implemented, that is the cramdown proposed in 2009 in congress and narrowly defeated. There was the potential to allow for a bankruptcy judge to have "the power to force a bank to lengthen loan terms, reduce interest rates and cut principal payments on a borrower's primary residence," according to Bloomberg's.

A cramdown in essence might allow for restructuring for the American people (just as the major banks were afforded) as it was estimated to help out more than 1 million Americans underwater on their home loans.

The best approach for fixing the financial crisis problem remains uncertain.

Two things are certain, however. The first is the growing wave of shadow inventory that the banks continue to control. The second is a "broad agreement that until we begin to stem the tide of foreclosures, you will not get an end to the current crisis," according to Representative Barney Frank.

For more information on the timeline of the financial crises:
Financial Crisis Timeline

Sources;
http://timeline.stlouisfed.org/index.cfm?p=timeline
http://www.ritholtz.com/blog/2010/10/shadow-inventory-an-avalanche-thats-coming-soon/
Video by James Ballard "St. Louis Fed President James Bullard discusses the origins of the financial crisis". Available online 1-5-11 at http://timeline.stlouisfed.org/index.cfm?p=timeline
http://www.cslb.ca.gov/generalinformation/library/guidesandpamphlets.asp
http://www.nytimes.com/2010/08/29/weekinreview/29goodman.html?pagewanted=all
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aoyMWtlsj27A
http://cr4re.com/charts/charts.html?Existing-Home#category=Existing-Home&chart=ShadowAugust2010.JPG