When “quantitative easing” (or “QE”) supplanted traditional monetary policy at the Federal Reserve last year, it marked the birth of “monetary policy 2.0”; the objective of which is to influence credit supply directly, in attempts to girder mortgage rates and suppress market volatility that otherwise threatens economic stability. In the short-term, this approach has proven effective, but the long-term risks remain unclear.

Nevertheless, it appears that (by no coincidence) REO asset-managers at banks simultaneously entered into the market manipulation ruse in hopes to gin up house prices, keeping them from cratering even further. From a bank’s perspective, doing this makes perfect sense. From a public policy point of view, the implication of this potentially new business model warrants examination.

“Zombie” Real Estate

I want introduce two relevant ideas: 

• Shadow Inventory
  Bank-owned or in-foreclosure properties that could be marketed for sale but are not; limbo inventory that flies below the MLS radar and not factored in inventory data cited by various trade groups.
  
• Zombie Banks                        
  Insolvent banking institutions able to operate only through government support. Though first coined in 1987 by Edward Kane during the S&L crisis (I Wiki, you?) it surfaced in the pubic lexica last year around the time Lehman, Fannie and Freddie went “poof”.

Both are interrelated terms as they result from the delay of market events that otherwise would take place in the absence of intervening forces.

Insolvent banks cause stresses in the system to fester, compromising investor confidence in the system itself. Thus, many argue, that preventing failures exacerbate the problems. Shadow inventory, regardless of the reason for it, delays the natural bottoming of prices necessary to facilitate home purchases at values that mirror the strength of the local economy. Preventing an all-at-once crash, perpetuates price stagnation as REOs mount over time and stall recovery as they enter the market.

The long-term wisdom behind what–for the purposes of this and furture posts–I call Real Estate QE, and the resulting zombie real estate it produces, is questionable. Indeed, in the near-term, the logic makes perfect sense because cutting off the supply of anything of utility will yield a higher price (thereby manipulating the curve in house prices). But I think the long-term impact is problematic.

“The market”, meaning everyone but the bank, can not know or anticipate what banks’ financial needs will be at any point in time. The risk is that if off-loading is in their interest at some unknowable period in the future, this could seriously dent in regular sellers’ price expectations. Put another way, regular homeowners looking to sell may find themselves competing with bank inventory in perpetuity. Can this relationship normalize, sure–but that remains to be seen.

The debate surrounding shadow inventory is on-going with even sides arguing its existence and/or significance. I personally believe the moving parts are too many to say for sure what the cause of it is, but if I were a bank, I’d be all about Real Estate QE.

Real Estate QE In Action

The following set of graphs are of the three-year sales history for single family residences within the 90650 zip code in Norwalk, CA.

In this graph, you see by the density of the “squiggles” that from July 2006 through about July 2007, the market was humming along fine. Right after July, which is when the credit crunch hit, the wave of foreclosure that were building all year long began flooding the market.

Pre-Crisis

 
Post-Crisis
 

 Post Fed QE and RE QE
 

Besides Federal Reserve QE, there were a host of things happening in this period that helped level off prices. Fannie/Freddie and FHA raised loan-limits; buyer tax-credits were enacted; interest rates were wrestled to the floor; the list is endless. And naturally, improved affordability contributed majorly, right?

The above “0-3 month” graph for most current 90 days tells the extent to which QE is working. The following table is of the current 12 months of sales and listings in the zip code.  

Zip level data for the past year in this area shows that absorption rates have been steady between 50 and 56 sales/month. This means the rate of homes selling hasn’t materially changed in more than a year. This, to a great extent, refutes the argument that “affordability” from reduced prices is the reason that prices stabilized. A lot can be drawn from this data, but we’ll go into the implications elsewhere.

Now, the supply side of this story is interesting. Active listings in the “7-12 month” period averaged 71 listings per month. In the subsequent 90-days that number inched up to 79 per month while sales slowed slightly to about 50/month. Over the most recent 90-days, however, supply dropped by ~24% from the period earlier and 15% from year-ago levels. This supply-squeeze created a pull-back in the 6-month trendline, yielding visible stabilization relative to the 12-month (not shown here).

A drop of 24% in inventory doesn’t mean much if the supply still exceeds 6 months. But when it nets only 3.2, it’s significant, especially within such a short time frame. And the proof is in the pudding, prices went flat.

But to get a sense of just how many foreclosures are lurking in the shadows, the follow maps reflect foreclosure activity 6 months ago, and this week for the same area.

Nov./Dec. 2008

 June 2009

RealtyTrac reported 6 months ago over 1,146 foreclosures at the zip-level; this month, over 1441 foreclosures were reported. This amounts to a 25.7% increase not reflected in supply trends. Note: “Foreclosures” here include all pre-foreclosures, properties at auction, and REO properties in the zip code.

It’s fair to question the ability of banking institutions and the Federal Reserve to sustain this nagging tension between supply (including zombie supply) and artificial demand (with QE-driven mortgage rates). I think we’ll just have to keep our eye on supply for cues.