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Massive Shadow Inventory 'Will Slow Down the Recovery’

As bad as the foreclosure situation has been, it could have been much worse, according to RealtyTrac, an online marketplace for foreclosed properties. And it may yet be, the firm’s Rick Sharga told a group of real estate writers assembled in Austin, Texas.

“The massive shadow inventory (of foreclosures that have yet to be put back out for sale in the open real estate market) will slow down the recovery,” the RealtyTrac senior vice president predicted. The increase in foreclosures over the last five years looks like a “teenager’s growth chart,” going from 530,000 notices in 2005 to 2.8 million last year, Sharga said at the National Association of Real Estate Editors’ annual conference. But if it wasn’t for government-enforced moratoriums on foreclosure filings and self-imposed delays, the number could easily have swelled in 2009 to as high as 3.5 million, he told the conference. “The number (of foreclosures) was really bad, but it could have been worse,” he said.

And it might be, according to RealtyTrac’s latest figures, which go on to predict that 3.5 million owners will receive foreclosure notices this year and a million more will get a dreaded default letter in their mail boxes next year.

The firm is predicting the increase in filings based on a combination of events—the number of unemployed borrowers who can no longer make their mortgage payments, a rising number of borrowers who won’t make their payment even though they can afford to, and the number of borrowers with option ARMs who are facing big jumps in their payments.

While optimists hope that many of those people already are in default, RealtyTrac takes a more pessimistic view. “The second wave of toxic loans is about to hit,” Sharga said, noting that the number of borrowers who will experience payment shock won’t peak until next year’s third quarter.

The firm projects that total foreclosure filings will reach 4.5 million by 2011, and while current loan modification programs will lessen their impact on the market, they will be largely “ineffective” in resolving the majority of problem loans, Sharga said.

“Foreclosure activity won’t stabilize until late 2011,” RealtyTrac’s senior vice president predicted. “The monthly level of foreclosures will not return to 'normal’ until 2012, but there will be high levels of REO inventories on the market through 2013.”

Another conference speaker, Jack Schakett of Bank of America, said he doesn’t think the number of option ARM borrowers who are facing big jumps in their payments will have much of an impact on the foreclosure numbers because lenders can see the increases coming.

It’s “easier to predict” a large jump in an option ARM borrower’s payment, and “easier to requalify” them for a loan modification that keeps their payments “very near” what they are now, said Schakett, B of A’s credit loss mitigation executive.

Consequently, lenders can start being proactive seven to nine months out. “If they want to stay in their homes,” he said, “I don’t think they’ll have problem” being able to do so. Sharga said that of the 800,000 or so REO properties presently being held by lenders, only about 300,000 are on the market. And that’s a mere drop in the bucket if firm’s projections are anywhere close to being on target.

With 1.2 million houses already in the foreclosure process and 5.5 million borrowers in some stage of delinquency, he said, the “most likely scenario” is that these distress properties will make their way to the market “very slowly” over the next three to four years.

“This will prevent another massive crash in home prices,” Sharga said. “But it will result in a long, slow, largely flat recovery.”