Fed Study Indicates Benefits from Speeding Foreclosure Process

by devteam September 7th, 2012 | Share

Researchers for the Federal Reserve Bank of Boston haverntaken a fresh look at the impact of foreclosures on the price of other homes inrna neighborhood using new data about the location of properties with seriouslyrndelinquent mortgages and their conditions. rnTheir results are likely to be controversial as they fly in the face of anyrnefforts to prevent foreclosure that prolong the delinquency period.</p

The results of thernstudy “Foreclosure Externalities:  SomernNew Evidence” was recently published by the authors Kristopher S. Gerardi, EricrnRosenblatt, Paul S. Willen, and Vincent W. Yao in the Federal Reserve’s Public Policy Discussion Papers.</p

Researchers base their argument that foreclosures reduce thernsale prices of nearby houses on studies using on a single flow of propertiesrninto the market, all of which have completed the foreclosure process.  The Fed study, in contrast, uses multiplernmeasures of the stock of distressed properties – properties with serious longrnterm delinquencies, shorter term less serious delinquencies, properties in bankrninventory (REO) and properties recently sold by the lender. </p

The paper posits that the stock of distressed housing isrnmore relevant than the flow of foreclosures because, for example borrowersrnfacing foreclosure have little reason to invest in their properties which couldrngenerate negative externalities in the neighborhood and distress nearby homernvalues.  This is important for policy</breasons if for example one assumes that distressed properties exert downwardrnpressure on the market but use only foreclosed properties to measure this.  One might erroneously assume that delaying orrnplacing a moratorium on foreclosures would cause prices to rise when it isrninstead the transitioning into delinquency which prompts homeowners to stoprninvesting in their properties.  A moratoriumrnwould actually increase the stock of distressed properties and thus the effectrnon surrounding homes.  The study also lookedrnat information as to whether a seriously delinquent property is vacant and onrnthe condition of lender-owned properties.</p

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.

All Content Copyright © 2003 – 2009 Brown House Media, Inc. All Rights Reserved.nReproduction in any form without permission of is prohibited.

About the Author


Steven A Feinberg (@CPAsteve) of Appletree Business Services LLC, is a PASBA member accountant located in Londonderry, New Hampshire.

See all blogs


Leave a Comment

Leave a Reply

Latest Articles

Real Estate Investors Skip Paying Loans While Raising Billions

By John Gittelsohn August 24, 2020, 4:00 AM PDT Some of the largest real estate investors are walking away from Read More...

Late-Stage Delinquencies are Surging

Aug 21 2020, 11:59AM Like the report from Black Knight earlier today, the second quarter National Delinquency Survey from the Read More...

Published by the Federal Reserve Bank of San Francisco

It was recently published by the Federal Reserve Bank of San Francisco, which is about as official as you can Read More...