Wednesday, 10 November 2010 11:47

The 3rd Quarter in Review, and More Importantly How the Shadow Inventory System in the US is Disguising the Equivalent of a Dozen Ambac Bankruptcies!

I feel this month has thrown enough events at the market to force it to start taking the real fundamentals into consideration. Of course, battling this ideal is the US Federal Reserve and their QE 2.1 policy. This should be a time to reflect upon exactly where we stand thus, I will review my thoughts and observations over the last 30 to 45 days and then summarize a truly unbiased and independently calculated view of the downright nasty side effects of the US shadow inventory of distressed housing. All paying subscribers can download the full shadow inventory report here: File Icon Foreclosures & Shadow Inventory. Professional and Institutional subscribers should also download the accompanying data and analysis sheet in Excel - Shadow Inventory.

Over the last few weeks, I have commented on my belief that the big banks who optimistically release reserves and provisions to pad lagging accounting earnings under the auspices of increasing credit metrics are simply setting their investors up for a major reversal which will bang those very same accounting earnings: JP Morgan’s 3rd Quarter Earnigns Analysis and a Chronological Reminder of Just How Wrong Brand Name Banks, Analysts, CEOs & Pundits Can Be When They Say XYZ Bank Can Never Go Out of Business!!! and ).

Although accounting earnings (the ink on the paper) have may have increased some, the economic profits and true value of these entities are still on the decline. The truth is the truth, no matter which way an accounting department attempts to spin it.  I have also commented on the obvious scam that the monoline insurers were in their attempt to insure a million dollars of highly leveraged and over valued assets with the equivalent of 25 cents - Banks, Monolines, and Ratings Agencies As The Three Card Monte (Wall)Street Hustlers! Its a Sucker’s Bet, Who’s Going to Fall for it in QE2?

I have also lamented on the still rapidly deteriorating condition of the residential housing market in the US: The Truth Goes Viral, Pt 1: Housing Prices, Economic Sales and the State of Depression and Yes, Housing Prices Have Much Farther to Fall. We’re Talking Years…

This is in direct contravention to the green shoots based opinions of entities such as the NAR: Pay Attention to the National Association of Realtors and Their Chief Marketing Agent At Your Own Risk! and even the significantly less biased, but still inaccurate Case Shiller index: Why the Case Shiller Index, Although Showing Another Downturn Coming, is Overly Optimistic and Quite Misleading!

The effects of the declining real estate will go way past mere affidavit scandals: The Robo-Signing Mess Is Just the Tip of the Iceberg, Mortgage Putbacks Will Be the Harbinger of the Collapse of Big Banks that Will Dwarf 2008!

Recently, my proclamation of the insolvency of Ambac Financial (Ambac is Effectively Insolvent & Will See More than $8 Billion of Losses with Just a $2.26 Billionn in Equity) rang true with the company's official filing, which itself was filled with smoke, mirrors and deceptions:

So, where do we stand after this link ridden, event filled 30 days or so? Well, the bankruptcy of Ambac is telling, for they succumbed to cash flow issues. They were definitely balance sheet insolvent, but to fall due to cash flows shows exactly how bad the mortgage market really is. You see, those CDS contracts were written quite favorably in Ambac's favor, allowing extended payout periods and relatively long loss tails (at least relative to what most may assume). It is not as if a claim appears and Ambac has to pay out everything the next day. If, even with the loss tails, assistance, government bubble blowing, ZIRP, and regulatory agencies officially looking the other way, the insolvent still fall into bankruptcy, then the proverbial "Houston, we have a problem!" soundbite is called for.

A few readers have emailed me asking for my opinion of the result of this slow motion train wreck. Well, outside of everyone staring down MBIA and its peer group, let's not forget who Ambac et. al. insured. Basically, at least in the structured finance space, they worked to allow banks to move junk assets to unwitting buyers and/or release risk reserves with a faux AAA or  near investment grade rating. In bankruptcy, I think its fair to say that Ambac is no longer investment grade - even to S&P and Moody's!!!

Well, I have identified a bank with around $32 billion of insured exposure to these guys (of course on  a highly levered basis). I am having my guys run the numbers and will get a reworked report out to subscribers as soon as possible. In the meantime, let's take a look at why I feel more than just a bank with $32 billion in levered, bankrupted monoline exposure is due to have problems...

Shadow inventory

The market’s inability to absorb the excess volume has created excessive “shadow inventory” that consists primarily of distressed, foreclosed and bank REO properties, but do contain several other categories of property as well. Most references to shadow inventory do not include the disgruntled existing home owner that has had to temporarily take their property off of the market due to weak demand, nor the new construction that has turned to rental waiting for the market to firm. As any sign of a firming market returns, there will be a deluge of supply to meet it, thereby throwing the supply/demand balance back to the supply side. We are doubtful that an actual housing recovery has commenced other than a short term reaction to government bubble blowing without the organic means to be self sustaining sans government assistance, and recent housing price data corroborates our conclusions. What has been referred to in the media as the “fledgling recovery” continues to remind us that we will not find equilibrium until the shadow inventory is exhausted and the excess problem loans are purged from the system. Foreclosed sales account for nearly a quarter of total national housing sales with an average discount of c26%. That number surpasses 55% in some states! Any foreclosure moratorium (such as the defacto ones we have now or the legislated one we had last year) further exacerbate the situation as pent-up foreclosures re-enter the market, compounding the problems at hand.

According to S&P, the principal balance of distressed homes is roughly $460bn and account for nearly one-third of the outstanding non-agency residential mortgage-backed securities (RMBS).  This is a very large number in relation to the tangible equity of the entities that hold these securities on their balance sheets on a leveraged basis. This also fails to take into account the full spectrum of the shadow inventory system, which has grown astronomically since the real estate/credit bubble has popped, mainly due to:

a) High delinquency and foreclosure rates which continue to mount;

b) Low cure rates, illustrating the failure of loan modification programs;

c) Longer liquidation times with delinquencies outstripping foreclosures

d) and, the combination of these three factors continuing to deteriorate in unison

We have quantified shadow inventory using the number of delinquent and foreclosure loans provided by Lender Processing Services and have applied delinquency cure rates these loans. Please keep in mind that this does not include the several prominent, yet harder to quantify, contributors to shadow inventory mentioned above. We have assumed a 25% cure rate for 30 day delinquent loan which have 3.4% delinquency rate, 10% cure rate for 60 day delinquent loan which have 1.4% delinquency rate, 0.5% cure rate for 90 day delinquent loan which have 4.4% delinquency rate and 0% cure rate for foreclosed loans. This gives a weighted average cure rate of 7.7%, broadly in-line with the historically optimistic Fitch, with estimates of 6.6% back in 2009 and 2.3% below data compiled by Lender Processing Service. Of the 13% delinquent and foreclosed units, we expect 12% of units to eventually liquidate. Overall this gives us total shadow inventory of 6.45m units. To put that into perspective, existing home sales total around 4.1m units implying the overhang is approximately 1.56x per year of existing home sales. We estimate that it would take about 6.2 years to clear the shadow inventory if foreclosure sales account for 25% of sales (7.8 years and 5.2 years if foreclosure sales account for 20% and 30% of existing home sales, respectively).

It is important to note that these figures only encompass loans that are already delinquent and does not includes loans which are current now but will go delinquent in the future and REO’s held by banks.

All paying subscribers can download the full shadow inventory report here: File Icon Foreclosures & Shadow Inventory. Professional and Institutional subscribers should also download the accompanying data and analysis sheet in Excel - Shadow Inventory.

I have supplied the raw data and empirical analysis to allow pro and institutional subscribers to get a full and accurate snapshot of the residential housing market. This includes a more granular application of our analysis on a state by state basis in the SCAP bank stress test template, and by region in the housing price and charge off templates through the following models:

You may subscribe to our services by clicking here!

Last modified on Wednesday, 10 November 2010 11:55


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