A Good Idea for Housing

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.

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