Arnold Kling  

Foreclosures and House Prices

GSE Reform and Tail Risk... Public Policy Bounty Hunting?...

Atif R. Mian, Amir Sufi, and Francesco Trebbi write,

We show that states that require judicial process for a foreclosure sale have significantly lower rates of foreclosures relative to states that have no such requirement. Using state laws requiring a judicial foreclosure as an instrument for actual foreclosures, as well as a regression discontinuity design around state borders with differing foreclosure laws, we show that foreclosures have a large negative impact on house prices. Foreclosures also lead to a significant decline in residential investment and durable consumption. The magnitudes of the effects are large, suggesting that foreclosures have been an important factor in weak house price, residential investment, and durable consumption patterns during and after the Great Recession of 2007 to 2009.

They are careful to say,

It is important to emphasize that we do not take a stand on whether foreclosures help to bring house prices, durable consumption, or residential investment closer to or further from their long-run socially efficient levels. For example, in the absence of foreclosures, house prices may display downward rigidity given loss aversion (Genesove and Mayer (2001)). Alternatively, house prices may be kept above their socially efficient level by government support. Further, it is conceivable that the declines we document would occur in the long run even in the absence of foreclosures; it is also conceivable that states where foreclosure is relatively easy will experience a faster housing recovery.

I want to say that I did not want to believe these results. I looked for flaws in their methodology, but instead I came away impressed that they anticipated all of my alternative lines of attack on the problem.

However, I had not thought of one factor. Itzhak Ben-David found that

mortgages owned by lenders were 26 to 36 percent more likely to be renegotiated than very similar mortgages that the original lenders sold to other companies, which turned them into securities.

It is conceivable that this could be a hidden variable that affects foreclosure rates in the Mian paper, although I doubt it. The number of loan modifications is small, and the number of unsecuritized mortgages is small, so that the effect on aggregate foreclosures is likely to be small. And I would not expect to be correlated with the instrumental variables used in the Mian paper.

The policy implications of the Mian paper are not clear. If a wave of foreclosures causes house prices to overshoot well below their long run equilibrium value, then you might want to try to spread out foreclosures. I think it is more likely that house prices have not fallen below equilibrium levels, and that postponing foreclosures has simply been putting off the inevitable market bottom.

Pointers from Mark Thoma.

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COMMENTS (5 to date)
Grant Gould writes:

This suggests an interesting strategy paradox, and a reason that you might want to believe this.

It might be that the best mortgage portfolio strategy for a bank is not to blindly geographically diversify, but to cluster its loans into a few tight groups (ideally in uncorrelated regions). A bank that owns all of the mortgage loans on a given city block can then internalize the benefits if modifying one mortgage will reduce the price drop (and thus default risk) of the neighbouring houses.

Which argues that more and wider bank branching and less securitizing and reselling of loans might be a good strategy -- rather close to your pre-existing view.

Various writes:

I think I know a thing or two about this subject. In my experience, nonperforming loans owned by a single institution (or in receivership by the FDIC) are more likely to be sold than loans residing in MBS and CMBS because the loan servicer has greater motivation to minimize losses and therefore sell the loans. This in turn is because the loan servicer and loan owner are usually the same institution. Regardless of this effect, my personal opinion is that because of the regional difference in judicial vs. nonjudicial foreclosure laws, the foreclosure and REO inventory overhang will probably be cleared out sooner in the western U.S., causing a more rapid R.E. recovery in the west starting somewhere around 2012. Because construction and industries related to real estate (e.g., brokerage, home remodelling, title insurance, etc.) constitute a significant chunk of GDP, this would imply a slightly more rapid economic recovery in the western U.S. beginning around 2012 or 2013. I think it is very possible that the recovery in residential real estate prices in the eastern U.S. could lag the west by 2 or 3 years.

Jon Leonard writes:

Why would this correlation be troubling? Foreclosing on a house leads fairly directly to it being sold, and an increase in supply drives down prices.

Limiting or delaying foreclosures (assuming that the bank is the proper owner of the house) increases the observed prices in a somewhat similarly to how a legislated minimum price would. That doesn't make either one a wise policy.

Milton Recht writes:

Foreclosed homes are sold "as is," cannot always be inspected prior to purchase and the purchaser is responsible for removing any residing tenant, previous owner or renter. A foreclosed home can be in terrible condition and require a sizable investment to make the house livable. Foreclosed abandoned homes can have their plumbing fixtures and appliances removed, walls, doors and windows broken, etc.

Foreclosed homes sell at a discount to non-foreclosed homes. Bloomberg reported, RealtyTrac compared the prices of foreclosed and non-foreclosed sales and found a 27 percent discount for foreclosures, .

The major home price averages combine foreclosed and non-foreclosed homes in their averages and indices.

Non-judicial foreclosure states have more foreclosure sales than judicial foreclosure states. Judicial foreclosure states will have fewer homes selling at an average 27 percent discount and naturally (mathematically) will reflect higher average sales prices than non-judicial sale states, which will have a greater volume of homes selling at the discount.

The behavioral characteristics of occupants may be different in judicial sale states versus non-judicial sale states. The length of time of owner/borrower occupancy post default is likely longer in judicial sale states because of the longer legal process and occupants likely have an interest in keeping things in better condition while they live there. Foreclosures in judicial states can take two years. The discounted price of foreclosed home sales may differ in judicial sales versus non-judicial sales states.

The question is whether the study put in enough controls for occupant behavioral differences in judicial and non-judicial states and whether the volume effect of the inherent discount of foreclosed homes on the home price index averages was adequately controlled for in the major home price indices and averages used in the study.

Chris Koresko writes:

Milton Recht: A foreclosed home can be in terrible condition and require a sizable investment to make the house livable. Foreclosed abandoned homes can have their plumbing fixtures and appliances removed, walls, doors and windows broken, etc... RealtyTrac compared the prices of foreclosed and non-foreclosed sales and found a 27 percent discount for foreclosures...

Perhaps this is a strong argument for policies that reduce the foreclosure rate. The lower selling price of a foreclosed home probably reflects a real destruction of wealth, unlike a mere fluctuation in the market price which is mostly just money changing hands.

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