'Shadow REO': As Many as 90% of Foreclosed Properties Held Off the Market

AOL Real Estate

07/13/12 - 02:25 PM EDT

By Teke WigginA pretty, manicured home sits six doors down from Phil Faranda's in Briarcliff Manor, N.Y.
To look at it, most passersby would think that the tidy house is occupied by a nice family that gives it a good amount of TLC: The lawn is mowed, the bushes trimmed, and the siding has what looks like a fresh paint job.
But Faranda knows better.
The bank-owned house has been vacant for 18 months, according to Faranda, a Realtor specializing in distressed properties. Just two notices taped to a window are the only indications that the home is unoccupied.
It might seem curious that such a well-maintained home doesn't have a For Sale sign on its front yard. But it's certainly not unusual.
This home is part of what's known as the "shadow REO" inventory: repossessed homes across the country that banks or investors often purposely keep off the market. The practice isn't a secret, and refraining from dumping a large inventory of foreclosures on the market helps to keep home prices from crashing.
But the extent to which lenders keep their stock of REOs -- industry parlance for "real estate owned" properties -- off the market may be much larger than most people think.
As many as 90 percent of REOs are withheld from sale, according to estimates recently provided to AOL Real Estate by two analytics firms. It's a testament to lenders' fears that flooding the market with foreclosed homes could wreak havoc on their balance sheets and present a danger to the housing market as a whole.
Online foreclosure marketplace RealtyTrac recently found that just 15% of REOs in the Washington, D.C., area were for sale, a statistic that is representative of nationwide numbers, the company said.
A Liability to Lenders
Analytics firm CoreLogic provided an even lower estimate, suggesting that just 10% of all REOs in the country are listed by their owners, which include mortgage giants Fannie Mae and Freddie Mac as well as the Federal Housing Administration. As of April 2012, 390,000 repossessed homes sat in limbo, while about 39,000 were actually listed for sale, said Sam Khater, senior economist at CoreLogic.
Daren Blomquist, vice president of RealtyTrac, said that he was surprised by his company's finding, especially since a similar analysis in 2009 found that banks were attempting to sell nearly twice as much of their REO inventory back then.
"It was surprising to see that that percentage had come down," he said, noting that many agents that his firm has spoken to "have mentioned that there's actually a shortage of foreclosure inventory -- and they're wanting more."
But Realtors who want more bargain-priced homes to sell may not get their way anytime soon. Foreclosed properties are an extreme liability to lenders, holding the potential not just to dent their profits but to actually bankrupt them altogether.
That's because when a lender carries an REO on its books, it is allowed to value the home at the price that the foreclosed-on borrower originally paid for it. Once the lender sells the home, it must book a loss: the difference between the original purchase price and the current value. And since home values have fallen by nearly a third since the housing bust, that translates into huge losses for the bank.
"They've already taken a loss on the loan," Khater said, "but they're going to take a loss on the asset once they dispose of it." Adding insult to injury, REOs typically sell at a 33% discount.
Fears of a Domino Effect
Releasing REOs onto the market also chips away at home prices in general, depressing the value of the homes of other customers -- who could already be teetering on the brink of foreclosure -- and the additional REOs that lenders hold on their books.
"Each REO that comes through has a domino impact on properties that are very close to that property," Khater said.
In fact, if lenders turn their REO release valve to full blast, the deluge of foreclosures cascading onto the market could plunge the country into a recession, said Thomas Martin, president of consumer advocacy group Americas Watchdog.
"If they let the dam essentially break. It could be a catastrophic disaster for the U.S. economy," he said, predicting that some major banks would fail and home prices would nosedive by 20 percent.
That doomsday scenario has many industry professionals supporting lenders' tactics of holding onto most of their REOs. Otherwise, they would be "causing the floor to fall out from underneath the entire market," Faranda said. He added that banks don't have the manpower to push the paperwork required to put all their foreclosures on the market.
Indeed, lenders couldn't list all their REOs even if they wanted to. Fannie Mae, for one, reported in the first quarter of 2012 that it was unable to market 48% of its REO inventory because many of the homes were either still occupied, under repair or being rented.
'Slowly Pulling Back the Band-Aid'
Banks and investors will likely continue to withhold REOs until the market value of the properties appreciates, allowing them to sell the homes at higher prices. And that may be a winning strategy.
Fannie Mae, which owned 114,000 foreclosed homes as of March 31, reported in the first quarter that there were "improved sales prices on dispositions of our REO properties, resulting from strong demand in markets with limited REO supply."
But at the same time, battening down REO inventory could prolong the housing slump, since the market must absorb the properties at some point anyway.
"As opposed to ripping off the Band-Aid quickly, it's kind of slowly pulling back the Band-Aid," Blomquist said.
Either way, he said, many lenders' REO-disposal tactics remain obscure, and that will continue to "create a lot of uncertainty in the market."