NEW YORK ( Real Money) -- Last Thursday, while most people were looking forward to a three-day weekend, the Federal Reserve's Board of Governors issued a statement reiterating the rules allowing banks to rent their real estate to tenants rather than sell it. That real estate is the residential properties the banks have acquired by way of foreclosure, known as "other' real estate owned, or OREO.The majority of these properties are concentrated in the money centers, with the largest percentage of them in Wells Fargo ( WFC), Bank of America ( BAC), and JPMorgan ( JPM). Following the 2008 financial crisis, "too big to fail" became "much too big to fail" as the insolvent mortgage banks were merged into the remaining money centers. In the process, Wells Fargo, Bank of America, and JPMorgan absorbed Wachovia/World Savings, Countrywide, and Washington Mutual, respectively. The result was an even larger concentration of residential mortgages and properties. These companies now control the largest percentage of what is known as the shadow inventory. For our purposes, we are using the most conservative definition of shadow inventory: properties acquired by the banks through foreclosure, as well as distressed sales in lieu of foreclosure, and those not yet marketed for sale. This inventory is massive, estimated at between five million and 10 million properties. To put this in context, there are about 110 million single-family dwellings in the US. Fannie Mae, Freddie Mac and HUD own about 250,000 of them. There are typically about four million residential property sales per year. How to dispose of the shadow inventory without putting further downward pressure on home prices is the quintessential issue facing the U.S. economy. The traditional method for a bank to dispose of real estate acquired through foreclosure is simply to sell it. Because of the size of the issue, that is not a realistic option. But the process of encouraging banks to become landlords represents some issues that investors should be mindful of. First, real estate owned, or REO, is a liability that must be reserved against, which is an inefficient use of capital and a drag on revenue and earnings. If the REO can be transferred into an off-balance-sheet entity and made to be positive cash flowing by way of incoming rent, the reserve issue goes away. That's very positive for the money centers, so investors should watch for them to move in this direction.
Second, this can cause the inventory overhang issue to disappear almost immediately. This issue has prevented potential buyers from buying and builders from building. If this issue is removed, it will provide a big catalyst for buyers and builders. The builders most positively affected will be those catering to move-up buyers. Toll Brothers ( TOL) is the name to watch here. The entry to mid-market builders will have an ongoing glut of rental properties that will slowly be converted to owner-occupied properties again over many years. Third, ownership and control of as much as 10% of the residential real estate stock in the U.S. will be concentrated in just a few money centers. This is unprecedented in U.S. history, providing new meaning to the term "landlord." From a societal standpoint, this is very dangerous and is best represented by the concept of rentier capitalism and wealth concentration, where wealth-owners receive what is called economic rent -- a positive real return without any corresponding risk. (Karl Marx coined the term rentier capitalism and warned that capitalism would destroy itself through this process.) Fourth, there are logistical issues associated with this process. If there has not been a third-party, arms-length transfer from seller to buyer, affording for price discovery, who determines a property's value, and thus tax treatment for local municipalities? From the perspective of the resolving the immediate crisis in housing, which is precluding real risk-taking and economic growth, this is a good start.