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Shadow inventory to push foreclosures to new heights

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Two reports from separate credit rating agencies are drawing the same conclusion: Foreclosures will reach new heights this year, even after setting records in 2010. It was hoped that mortgage delinquencies, and subsequent foreclosure filings, had peaked. Until that moment, the stockpile of properties facing imminent default, the "shadow inventory," will continue to threaten to further glut real estate market supply, with downside knock-on impact. "DBRS expects foreclosure filings and completed foreclosures to reach record levels in 2011 as alternatives such as modifications for seriously delinquent borrowers are exhausted," said Kathleen Tillwitz, an operational risk strategist at the rating agency. "Consequently, losses to residential mortgage-backed securities will likely increase as REO inventories are sold at deep discounts causing writedowns in transactions — particularly the subordinate tranches." Standard & Poor's ratings currently estimates that the principal balance of distressed homes amounts to about $450 billion, representing nearly one-third of the nonagency RMBS market currently outstanding, according to the firm's fourth quarter 2010 report on foreclosure timelines, also released this week. "We define this yet-to-be absorbed shadow inventory of distressed properties as outstanding properties whose borrowers are 90 days or more delinquent on their mortgage payments, properties currently or recently in foreclosure, or properties that are real-estate owned," the report said. S&P expects that it will take 49 months to clear the supply of distressed homes on the market in the U.S. — an 11% increase over the previous quarter and a considerable 40% increase from 4Q 2009. The delay in foreclosures is due primarily to improper documentation slowing down the liquidations of properties. Mortgage servicers will likely see regulation in 2011 on standardizing this process, but until then, everyone except the delinquent borrower will have to pay. "As lenders and servicers are forced to compensate borrowers for errors and defend themselves against the massive amounts of litigation they will be facing in 2011 due to mistakes, servicing fees in securitizations and/or fees paid by the borrower for ancillary items will likely increase," said Tillwitz. "Some of these items may include origination fees, closing costs, modification fees, phone pays, appraisals, late payment fees and other supplementary costs associated with the origination and servicing mortgage loans." To be sure, S&P reports that the volume of distressed residential mortgage properties that are not associated with Fannie Mae or Freddie Mac continues to fall, but at an ever-slowing pace. S&P estimates that the principal balance of these distressed homes amounts to about $450 billion, representing nearly one-third of the private RMBS market outstanding. And in some markets, clearing the shadow inventory will take a very long time, in one market in particular. "The shadow inventory in the New York MSA will take the longest to clear — 130 months as of fourth-quarter 2010. That is at least twice as long as it will take in any of the other top 20 MSAs and 2.7 times the average time to clear for the U.S. as a whole," the S&P report states. "This is primarily due to very low liquidation rates in New York." Foreclosure market data according to the largest states is available by clicking the chart below:

Write to Jacob Gaffney. Follow him on Twitter @JacobGaffney.

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