Do foreclosures really cause price declines?

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August 6, 2010
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Today I came across a recent study on foreclosure sales and house prices by an MIT economist and two Harvard researchers. MIT just issued a press release so the study is now making headlines.The researchers looked at 1.8 Million transactions in Massachusetts over the last 20 years and came to the conclusion that homes sold after foreclosure sell at a particularly large discount of 27% on average. Further they find that "each foreclosure that takes place 0.05 miles away lowers the price of a house by about 1%". Wow. I sure hope there haven't been 100 foreclosures near you.

I've long believed that foreclosures DO NOT cause price declines, and after reading this study my view has NOT changed. My view instead is that price declines cause foreclosures, but there's a twist to this view, that I believe threw these researchers off track and led them to a faulty conclusion despite an otherwise interesting paper. They are not alone. I think most people actually believe foreclosure cause prices declines. The key to the author's error, I believe, can be found in the following sentence: "To the extent that house prices drive foreclosures, low prices should precede foreclosures rather than vice versa." Through various regression tests they found this NOT to be the case, which would seem to strongly support their conclusion over mine.

Here's the rub - home prices are a function of income and loan terms. As such the price buyers in a given area can afford to pay often declines PRIOR to being actually reflected in market sales. Massachusetts unemployment went from 6 to 9% in 1990, hitting many households and leaving them unable to pay their mortgages, and impacting what potential buyers could afford to pay as well. In 2007 over-indebted subprime borrowers with 100% LTV, teaser rate, neg-am, loans and no skin in the game began walking away as builders started discounting the same homes those borrowers were told would only go up in value. Those subprime defaults led lenders to pull the exotic loans that previously enabled buyers to "afford" twice as much home as they could using more traditional loan products. Sales then stalled as unforced sellers were unwilling or unable to drop prices.

This leads to the part that seems to confound everyone, including this study's authors. Banks taking back foreclosures are forced to sell at the price buyers can afford. Thus foreclosures are the first sales to begin occurring in large numbers at the price level that buyers can now afford. As they do, nearby unforced sellers come to grips with the new market reality, while others that don't have foreclosures nearby cling to the hope that their home won't be affected. That hope is kept alive by a trickle of sales that continue to occur at prior price levels as not all buyers are impacted by economic changes equally.

Thus even though foreclosures are the first to sell at lower prices, they did not CAUSE prices to be lower.

I'll leave you with this simple example: there was really no decline in California's median price, despite mounting foreclosures and an increasing percentage of foreclosures sales until September 2007 credit crisis. At that time banks panicked and removed the exotic loans that had enabled the high prices in the first place, at which point the median price tumbled to a level the median income family could afford using the more traditional loan products that remained in the market. Remember, the typical homebuyer can only afford as much home as their banker tells them they can afford.

Today I came across a recent study on foreclosure sales and house prices by an MIT economist and two Harvard researchers. MIT just issued a press release so the study is now making headlines.The researchers looked at 1.8 Million transactions in Massachusetts over the last 20 years and came to the conclusion that homes sold after foreclosure sell at a particularly large discount of 27% on average. Further they find that "each foreclosure that takes place 0.05 miles away lowers the price of a house by about 1%". Wow. I sure hope there haven't been 100 foreclosures near you.I've long believed that foreclosures DO NOT cause price declines, and after reading this study my view has NOT changed. My view instead is that price declines cause foreclosures, but there's a twist to this view, that I believe threw these researchers off track and led them to a faulty conclusion despite an otherwise interesting paper. They are not alone. I think most people actually believe foreclosure cause prices declines. The key to the author's error, I believe, can be found in the following sentence: "To the extent that house prices drive foreclosures, low prices should precede foreclosures rather than vice versa." Through various regression tests they found this NOT to be the case, which would seem to strongly support their conclusion over mine.Here's the rub - home prices are a function of income and loan terms. As such the price buyers in a given area can afford to pay often declines PRIOR to being actually reflected in market sales. Massachusetts unemployment went from 6 to 9% in 1990, hitting many households and leaving them unable to pay their mortgages, and impacting what potential buyers could afford to pay as well. In 2007 over-indebted subprime borrowers with 100% LTV, teaser rate, neg-am, loans and no skin in the game began walking away as builders started discounting the same homes those borrowers were told would only go up in value. Those subprime defaults led lenders to pull the exotic loans that previously enabled buyers to "afford" twice as much home as they could using more traditional loan products. Sales then stalled as unforced sellers were unwilling or unable to drop prices.This leads to the part that seems to confound everyone, including this study's authors. Banks taking back foreclosures are forced to sell at the price buyers can afford. Thus foreclosures are the first sales to begin occurring in large numbers at the price level that buyers can now afford. As they do, nearby unforced sellers come to grips with the new market reality, while others that don't have foreclosures nearby cling to the hope that their home won't be affected. That hope is kept alive by a trickle of sales that continue to occur at prior price levels as not all buyers are impacted by economic changes equally.Thus even though foreclosures are the first to sell at lower prices, they are not the CAUSE behind those lower prices.I'll leave you with this simple example: there was little decline in California's median price, despite mounting foreclosures and an increasing percentage of foreclosures sales, until the September 2007 credit crisis. At that point the median price began to rapidly tumble to a level the median income family could afford using the more traditional loan products that remained available in the market. Bottom line, the typical homebuyer can only afford as much home as their banker tells them they can afford. As such changes in household incomes typically due to rising unemployement and/or the tightening of loan terms used to qualify buyers are what cause price declines, not foreclosures.

Written by:
Written on:
August 6, 2010
Category:
Not Categorized