Foreclosures and House Prices
By Arnold Kling
We show that states that require judicial process for a foreclosure sale have significantly lower rates of foreclosures relative to states that have no such requirement. Using state laws requiring a judicial foreclosure as an instrument for actual foreclosures, as well as a regression discontinuity design around state borders with differing foreclosure laws, we show that foreclosures have a large negative impact on house prices. Foreclosures also lead to a significant decline in residential investment and durable consumption. The magnitudes of the effects are large, suggesting that foreclosures have been an important factor in weak house price, residential investment, and durable consumption patterns during and after the Great Recession of 2007 to 2009.
They are careful to say,
It is important to emphasize that we do not take a stand on whether foreclosures help to bring house prices, durable consumption, or residential investment closer to or further from their long-run socially efficient levels. For example, in the absence of foreclosures, house prices may display downward rigidity given loss aversion (Genesove and Mayer (2001)). Alternatively, house prices may be kept above their socially efficient level by government support. Further, it is conceivable that the declines we document would occur in the long run even in the absence of foreclosures; it is also conceivable that states where foreclosure is relatively easy will experience a faster housing recovery.
I want to say that I did not want to believe these results. I looked for flaws in their methodology, but instead I came away impressed that they anticipated all of my alternative lines of attack on the problem.
However, I had not thought of one factor. Itzhak Ben-David found that
mortgages owned by lenders were 26 to 36 percent more likely to be renegotiated than very similar mortgages that the original lenders sold to other companies, which turned them into securities.
It is conceivable that this could be a hidden variable that affects foreclosure rates in the Mian paper, although I doubt it. The number of loan modifications is small, and the number of unsecuritized mortgages is small, so that the effect on aggregate foreclosures is likely to be small. And I would not expect to be correlated with the instrumental variables used in the Mian paper.
The policy implications of the Mian paper are not clear. If a wave of foreclosures causes house prices to overshoot well below their long run equilibrium value, then you might want to try to spread out foreclosures. I think it is more likely that house prices have not fallen below equilibrium levels, and that postponing foreclosures has simply been putting off the inevitable market bottom.
Pointers from Mark Thoma.