Millions of homeowners have lost their homes to foreclosure because they owed more on them than they were worth. Now a new study from two economists at the Cleveland Federal Reserve suggests that some homeowners in poorer markets are losing their homes because their lenders inaccurately overvalue them.
In weaker markets strapped with swelling foreclosure inventories, weak demand and blighted neighborhoods, homes actually cost more to maintain than lenders can expect to sell them for. Homes entering foreclosure and lingering in REO (bank-owned) status in weak markets tend to be older and of lower quality than homes entering REO in strong markets. Property in weak markets is more likely to be vandalized while sitting in REO, and older housing stock tends to deteriorate more rapidly. Weak demand depresses overall housing prices. As a result of overvaluation, lenders are foreclosing when they would be better off modifying the loan or finding another way to avoid ending up with another REO, the economists argue.
Property sitting in REO is expensive for lenders. Lenders must keep their REO properties secure, bring them up to local housing codes, maintain them, pay property taxes, and market them for resale. Meanwhile, neighborhoods wrestle with increased vacancy and its consequences, as the vast majority of REO properties are vacant.
Authors Thomas J. Fitzpatrick IV and Stephan Whitaker analyzed foreclosures in Cuyahoga County, Oho from January 2006 to June 2011 and found that at least a quarter of long-held properties are complete losses and even if a home sells after five quarters on the market as a foreclosure, the median loss taken by lenders is roughly 80 percent of the auction price. They properties sold at auction resold at an average of 26.5 percent less than they cost at auction. Federal agencies did worse on average than investors, but better than lenders, selling properties out of REO for about 30 percent less than their auction reserves. Lenders tended to sell property out of REO for 42 percent less than the auction price.
"There are three forces that very likely combine to create the trend of higher losses the longer properties stay in REO. First, the higher-quality REO properties in any price range exit REO within the first few months. Those that take longer to sell are probably the ones that were in relatively poor condition when repossessed. Second, the homes may be rapidly deteriorating while the lenders own them. The lower-value homes in distressed neighborhoods are often vandalized and stripped of metals. Despite winterization, homes may suffer weather-related damage without an attentive occupant to immediately address problems when they arise. A third, potentially contributing factor, is any downward trend in home prices that occurs while homes sit in REO. Certainly, such a trend occurred in Cuyahoga County (Cleveland), over the period we studied, owing to the growing supply of REO and recently foreclosed homes, along with weakening demand for property in distressed areas. In any case, what lingers is worth far less than the price the lender pays at auction," wrote Fitzpatrick and Whitaker.
Because foreclosure rates have been elevated for so long and housing demand has been weak, the number of properties repossessed by lenders has ballooned. Property values don't take into account the discounted value foreclosures have once they reach REO status. As a result, property values are being systematically overestimated by appraisers, investors, and lenders. Overestimating the value of a foreclosed home leads lenders to set too high a minimum bid at the sheriff's sale, which lowers the chance that someone will buy the home at the auction and take it off the lender's hands.
The economists found signs that in weaker markets appraisers, lenders, and investors are routinely overestimating the property values of foreclosed homes because they are not taking into account what their marketplace value as REOs will be. In theory, at sheriff's auctions in a judicial state like Ohio the lender should be setting the minimum bid based upon what it could obtain by selling the property, less carrying and transaction costs. Lenders typically obtain a real estate broker's price opinion or a "walk around" appraisal, and then they calculate expected costs and value the property accordingly. In Cuyahoga County it is unclear if lenders are relying on the foreclosure appraisal or if they are obtaining additional valuations of the property. If no buyer, including the lender, offers the minimum bid at the auction, the property is re-auctioned the following week.
Instead of relying upon auction bids or traditional valuation methods, which may not be working well in weaker markets, lenders should place more weight on simple property characteristics—the age of the home and its location—in their value estimates, to more accurately price property in weak housing markets.
More accurate pricing could lower REO carrying costs by setting their auction reserves lower and allowing others to purchase more properties at auction, by making more loan modifications and by reducing the number of foreclosures they initiate. Accurate pricing could also lower carrying costs is by helping lenders identify the properties that have the least value early in the foreclosure process and facilitate their disposition to land banks, local governments, or community development corporations seeking to remediate blight.