Fed Study: Overpriced Foreclosures Hiking REO Carrying Costs

Appraisers, lenders, and investors appear to be routinely overestimating the values of homes prior to foreclosure, especially in the weakest housing markets, according to two economists with the ""Federal Reserve Bank of Cleveland"":http://www.clevelandfed.org.

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The Cleveland Fed's Thomas Fitzpatrick and Stephan Whitaker suggest that more accurate pricing could speed the clearing of REO inventories, save lenders money by reducing the carrying costs associated with bank-owned homes, and bring greater stability to housing markets across the country.

Analyzing data from Cuyahoga County, Ohio (where Cleveland is located) the researchers found that lenders and other buyers at county foreclosure auctions tend to resell acquired properties for a fraction of what they paid at the auction.

Lenders tend to sell property out of REO for 42 percent less than the auction price, according to the Cleveland Fed economists. The pair assessed 16,012 foreclosed properties in Cuyahoga County that were taken back by the lender at foreclosure auction between 2006 and 2011. Lenders’ total losses on the pool of properties â€" calculated as the difference between a property’s auction reserve and the sale price at the exit from REO â€" amounted to $326.2 million.

In a ""report detailing their findings"":http://www.clevelandfed.org/research/commentary/2012/2012-03.cfm, Fitzpatrick and Whitaker contend that placing more weight on two simple property characteristics - a home's age and its location -

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would improve the accuracy of appraisals in weak housing markets.

With more precisely targeted values for homes prior to foreclosure auction, the researchers say lenders could lower their REO carrying costs in a number of measurable ways:

* Lenders could avoid taking on REO altogether by setting their auction reserves lower and allowing others to purchase more properties at auction.

* Lenders would be more likely to offer loan modifications, and not initiate foreclosures, on low-value properties.

* Identifying properties that have the least value early in the foreclosure process would facilitate their disposition to land banks or other organizations seeking to remediate blight.

The Fed economists stress that problems arising from swollen REO inventories â€" including costs to lenders and neighborhood blight â€" are compounded in weak housing markets where the supply of housing exceeds the demand for it. They say several factors combine to increase the odds that REO homes will actually cost more to maintain than lenders can expect to bring in from their sale.

For example, carrying costs are likely to be higher when you factor in securing the properties, bringing them up to local housing codes, properly maintaining them, shelling out money to cover property taxes, and marketing them for resale.

Homes entering foreclosure and lingering in REO in weak markets tend to be older and of lower quality than homes entering REO in strong markets, the researchers note. In addition, homes in weak markets are more likely to be vandalized while sitting vacant and older housing stock will typically deteriorate more rapidly. To top it off, anemic demand for housing in such markets further depresses overall housing prices.

In weak markets, Fitzpatrick and Whitaker contend that lenders may be better served by not taking properties into REO in the first place, or at least minimizing the time repossessed homes spend in REO by donating them to land banks or nonprofits.