The paper sets out two empirical facts.  1) Houses that sell very close to all formsrnof distressed properties do so at a slightly lower price than otherwise similarrnproperties in the same Census Block Group (CBG) that sell without nearbyrndistressed properties and 2) the effect appears when the borrower becomesrnseriously delinquent on the mortgage and disappears one year after the lenderrnsells to a new homeowner in an arms-length transaction.</p

The research evaluated three possible explanations forrndepressed prices.  </p

1. Unobserved relative demand shocks that drive down pricesrnand result in some foreclosures.</p

This has support both in theory and data.  Default makes sense for a borrower only if hernis in a position of negative equity.  “Allrnelse being equal, a negative demand shock in location A relative to location Brnwould lead to a fall in prices in location A and a concomitant increase inrnnegative equity and foreclosures.”</p

The fact that demand theory could explain the observationsrndoes not necessarily mean that it does. rnOne could argue that it is unlikely for significant property depreciationrnto occur when borrowers have only missed a few mortgage payments, but he datarnindicates that this is the case.  Anrnargument could be made for reverse causality however it could be that thernborrower has been in financial distress for some time and has deferred propertyrnmaintenance. </p

Other facts are inconsistent with the demandrnexplanation.  First the effects diminishrnsignificantly for nearby properties a year after the subject property is soldrnout of REO.  The second problem is thernvariation within CBGs which would negate both a demand and a supply theoryrnunless one believed there were distinct submarkets within a CBG – which have arntarget size of about 1,500 people – and that one part of the submarket sufferedrna shock that did not affect the other.</p

2. Foreclosures generating increased relative supply and drivingrndown prices.</p

The supply theory posits that a foreclosure increases thernsupply of property on the market and drives down prices.  Normally, when pricing long-lived assets likernhouses the supply is defined as all of such assets that exist, whether on the marketrnor not.  Foreclosures do not change thernnumber of houses or the quantity of land so standard models would not predictrnany effect on prices.</p

The authors engage in a lengthy discussion of the impact ofrnforward looking buyers skewing the market by anticipating the future availabilityrnof foreclosed homes but concludes that the supply theory, while it couldrnexplain why prices rise after the REO is sold (with the house off the marketrnits price as well as those of other houses return to pre-delinquency levels) itrndoesn’t explain why properties in above average condition don’t have the samerneffect as those below average in generating competition with other properties.</p

3.  An externality of reduced investment by distressedrnborrowers in the delinquency phase and financial institutions in thernlender-ownership phase.</p

The third explanation is that foreclosures lead to anrninvestment externality.  Neitherrndelinquent borrowers nor lenders have an incentive to adequately maintain thernproperty which leads to physical deterioration and reduces the value of nearbyrnproperties as well.  This investmentrndisincentive is arguably present both during serious delinquencies and when thernproperty is in REO.    Borrowers do notrninvest in their properties under this scenario either because they have nornfunds to do so or because they see no gain as they expect to lose ownership inrnthe future.  Post foreclosure the lenderrndoes not obtain any consumption benefit from investing in the property and thernREO process suffers from an information problem where the property agent has nornownership stake and the owner/lender cannot be sure if the manager has otherrnincentives.  The optimal mechanism forrninvestment in single-family residential real estate is to sell the property torna small-scale investor who internalizes the costs and benefits.</p

The literature supports the investment externality argumentrnand the authors find that is also explains why the coefficient estimaternassociated with nearby below average REO is far lower than where the REO is inrnaverage condition and why the difference disappears after a new arms-lengthrnowner has had a chance to invest in the property.</p

The authors sum up their research by saying that perhaps thernmost important take-away is that the effects of foreclosure and distressedrnproperty in general on the prices of a neighboring home are fairly small.  They estimate that the effect of a propertyrnwith a seriously delinquent mortgage and a property in REO on the price of arnhome within 0.10 mile to be approximately -0.5 to -1.0 percent, “an amount thatrnwould most likely go unnoticed by the typical seller who does not have manyrndistressed homeowners living nearby.  Thernvast majority of properties that sell have no distressed properties nearbyrnwhich means that “it is impossible to attribute more than a token amount of therncollapse in prices in the 2006-10 period to foreclosures.”</p

The authors’ final conclusion is bound to berncontroversial.  “The policy implicationsrnof even a small investment externality effect are important.  Our results suggest that the key tornminimizing the costs of foreclosure is to minimize the time that propertiesrnspend in serious delinquency and in REO.” rnThis implies a need to pressure banks to get properties out of REOrnquickly and to minimize the time a borrower spend in serious delinquency whichrnmeans accelerating the foreclosure process, avoiding moratoria, and perhapsrneven foregoing extended loss mitigation efforts.

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