There are many myths about housing markets perpetuated by banks and the financial press. Two of these myths include (1) keeping people in a house keeps up the values, and (2) foreclosures reduce neighborhood values.

Many believe that allowing delinquent mortgage squatters to stay in place improves the condition of a property. Perhaps in rough neighborhoods prone to property crime, occupancy is better than abandonment, but in most neighborhoods, when delinquent mortgage squatters stay on, they property gets run down. Why would anyone spend any money to improve or even maintain a property in which they have no financial interest? If people were prone to do this, then landlords wouldn’t need to spend money maintaining rentals. Delinquent mortgage squatters have no landlord to call, so when something breaks, unless it makes the house unlivable, it goes unfixed. A property in poor condition is worth less than a well maintained one.

Many also believe that foreclosures reduce neighborhood values. Another recent federal reserve study concluded the conventional wisdom is wrong, foreclosures don’t reduce neighborhood values. I have long contended that foreclosures are not the problem, they are the cure. The real problem is, and always has been, property debt. Foreclosure removes that problem. Further, once a house goes through the foreclosure process and gets sold to a new owner, the value of that home rises to the general level of the neighborhood. Either the flipper who bought the foreclosure or the new owner improves the property to fix the problems left over from the delinquent former owner who didn’t maintain it.

As lenders have played the amend-extend-pretend game, they have allowed people to squat for as long as five years in some of these properties. The longer lenders allow these people to squat, the more these properties become run down, and the more neighborhood values drop. It’s really that simple. Plus, the cure for this problem is equally simple: foreclose on the squatters and recycle the property into the hands of a new homeowner who will care for it. But don’t take my word for it, read the report:

Foreclosure Externalities: Some New Evidence

Kristopher Gerardi, Eric Rosenblatt, Paul S. Willen, and Vincent W. Yao

Working Paper 2012-11 August 2012

Abstract: In a recent set of influential papers, researchers have argued that residential mortgage foreclosures reduce the sale prices of nearby properties. We revisit this issue using a more robust identification strategy combined with new data that contain information on the location of properties secured by seriously delinquent mortgages and information on the condition of foreclosed properties. We find that while properties in virtually all stages of distress have statistically significant, negative effects on nearby home values, the magnitudes are economically small, peak before the distressed properties complete the foreclosure process, and go to zero about a year after the bank sells the property to a new homeowner. The estimates are very sensitive to the condition of the distressed property, with a positive correlation existing between house price growth and foreclosed properties identified as being in “above average” condition. We argue that the most plausible explanation for these results is an externality resulting from reduced investment by owners of distressed property. Our analysis shows that policies that slow the transition from delinquency to foreclosure likely exacerbate the negative effect of mortgage distress on house prices.

The decline in value, the “negative effects,” peak before the properties complete the foreclosure process. If the decline in value were caused by the foreclosure, the values would remain unchanged until the bank listed and sold the property. That isn’t what the researchers found. This has huge implications because now banks can foreclose under the guise of improving property values.

Just say no to foreclosure moratorium

The recent change in laws in Nevada which essentially caused a statewide moratorium over the last year. The reduction in inventory also caused house prices to bottom and rise nearly 10% this year. Such occurrences would suggest broader foreclosure moratorium would help prices bottom in other locations. That is not the conclusion of the federal reserve.

Because foreclosure transitions in a given area are highly correlated with the number of outstanding distressed properties in the same area, one would find a significant, negative correlation between the sale price of a non-distressed property and the number of surrounding properties transitioning into fore- closure. Based on such results, one might conclude that implementing a fore- closure moratorium would increase house prices. However, such a conclusion would be wrong. Delaying transitions into foreclosure does not reduce the to- tal number of distressed properties, which is what exerts downward pressure on prices according to the true model. Indeed, over time, delaying foreclosures without stopping transitions into delinquency would increase the total number of distressed properties and thus serve to lower prices.

Wow! That could have been written on this blog. I have made the same argument for years. It’s shocking to see this kind of common sense in an academic study supported by real data and analysis put out by the federal reserve. There is hope for them yet.

Conclusions by the federal reserve

So what big-picture conclusions did the federal reserve economists draw from this work?

Houses that sell very close to all forms of distressed property appear to do so at slightly lower prices than otherwise similar properties in the same CBG that sell without the presence of nearby distressed properties. The effect appears when the borrower becomes seriously delinquent on his mortgage and disappears one year after the lender sells the foreclosed property to a new homeowner in an arms-length transaction. What can explain these empirical observations? … This refers to the tendency of financially distressed borrowers and lenders that do not derive consumption services from foreclosed property to underinvest in property maintenance, leading to physical deterioration of the property and, in turn, causing a reduction in the value of nearby property to potential buyers.

They examined other possible explanations and came to these conclusions:

The idea that a fall in demand leads to a fall in prices and an increase in foreclosures has strong support in theory and in the data. Default makes sense for a borrower only if he is in a position of negative equity, that is, if his mortgage debt exceeds the value of his home, and it is difficult to have negative equity without falling prices.

People who cannot afford their property yet have equity do not become foreclosures. They sell in an open market to obtain their equity. Foreclosures become much more common as borrowers submerge beneath their debts because they have few other options to get out from under their debt burdens.

The fact that the demand theory could explain the observed facts does not necessarily mean that it does explain them.

… a borrower who has only missed a few payments may have been in financial duress for quite some time, in which case the lack of investment in property maintenance might be a plausible explanation for the negative coefficient estimate associated with minor DQs.

The study found even being a little bit underwater cause many people to default. It suggests those defaults were caused by payment duress rather than strategic default from a borrower with little or no duress.

A popular alternative to the demand theory is the supply theory, which posits that a foreclosure increases the supply of property on the market and drives down prices. Unlike the demand theory, the supply theory is not an obvious consequence of standard economic theory. Normally, when we price long-lived assets like houses, we define supply as all of the assets that exist, not just the ones currently for sale. Foreclosures do not change the number of houses or the quantity of land in a market, so standard models would not predict any effect on prices.

The standard model does not take into account seller motivation. We could put every house in the country for sale tomorrow, and it wouldn’t impact prices. Most people would simply list their house at some ridiculous WTF listing price and have no impact on the market. Their motivation would be very low, so the price would reflect that. A classic example of this phenomenon is the “make me move” price on Zillow. It is a repository for the delusions of unmotivated sellers everywhere. If you have never checked these out, they are worth a laugh.

The supply story could potentially explain why prices rise after the REO sale: with the property now off the market, prices recover to their pre-delinquency level.

That’s exactly what happens. It’s also why beaten down markets across the Southwest are seeing 10% increases in price this year. The supply of REO by motivated sellers is reduced, so prices are bouncing back up to a new equilibrium. With interest rates being so low, buyers have some room to raise their bids, so we are seeing a sharp rebound rally. Of course, this only works as long as interest rates are very low and supply is unduly constricted. It is also going to cause sales volumes to plummet. We may see record low sales volumes over the next several months.

There are two reasons why seriously delinquent borrowers are unlikely to maintain properties. The first is that many of them have suffered cash-flow-depleting life events and discount future consumption heavily relative to current consumption. Effectively, this raises the hurdle rate on any investment in the property. The second problem is that many seriously delinquent borrowers expect to lose their homes and therefore, the long-term benefits of any investment would accrue to the ultimate owner of the property—the lender.

They got that one right. No delinquent mortgage squatter is going to improve the lender’s house.

The issue is that the amount of profitable investment in the property is a matter of discretion, and the owner of the property cannot be sure whether the manager has other incentives. As with all standard asymmetric information problems, the result would be a failure to exploit profitable gains from trade, in this case, investment in the property. Another way to put this is that the optimal mechanism for investment in single-family residential real estate is to sell the property to a small-scale investor who internalizes the costs and benefits.

Banks will not spend money improving a property even if it’s in their best interest to do so. It’s nearly impossible for an asset manager to quantify the increase in value, but it’s very easy to quantify how much more money the bank dumps into a losing loan. It’s easier and often wiser to error on the side of spending as little as possible and getting out as quickly as possible. Renovations can quickly become white elephants eating a bigger hole in a bank’s balance sheet.

So what does this report lay the groundwork for?

I think we are going to see a shift back away from short sales toward foreclosure. Right now, banks stopped foreclosing in hopes of getting more delinquent mortgage squatters to list their homes and sell them short. The losses on the short sales count toward the $25 billion settlement figure with the attorneys general across the country. However, as I have pointed out a number of times, short sales require the participation of the owner, and the people not paying their mortgages benefit far more from doing nothing than they do by participating in a short sale. If they do nothing, they get to live for free. If they complete a short sale, they will have to move out of their home and start paying rent. What is their incentive to do that?

Now that the federal reserve has acknowledged that delinquent mortgage squatters reduce neighborhood values and foreclosures improve them — whether this is accurate or not — it gives the GSEs and the member banks of the federal reserve a reason to start foreclosing again — or perhaps more importantly, it gives them some political cover to start foreclosing again. Now, banks can make the argument that foreclosing on the squatters improves neighborhood values. They can push back against the anti-foreclosure left-wing pander movement which opposes foreclosures.

I believe we will see a significant increase in foreclosures to process shadow inventory. House prices are moving up, MLS inventory is at acutely low levels, the GSEs are winding down their holdings, potential buyers who were foreclosed on three or more years ago have recovered credit, and the federal reserve has provided cover for the banks to push out the squatters. It may not be the perfect storm, and it may not result in a huge crash in prices, but we should start to see more foreclosures and more homes on the MLS. The only question is when.