As discussed in a recent article from MarketWatch, “A new working paper authored by researchers at Boston University and Stanford University investigates the ways in which foreclosures exacerbate a housing bust and reduce prices for non-distressed homes. The researchers also investigated foreclosure mitigation approaches and proposed a novel way through which government officials could stem the onset of future housing downturns.’
Abstract
This paper uses a structural model to show that foreclosures played a crucial role in exacerbating the recent housing bust and to analyze foreclosure mitigation policy. We consider a dynamic search model in which foreclosures freeze the market for non-foreclosures and reduce price and sales volume by eroding lender equity, destroying the credit of potential buyers, and making buyers more selective. These effects cause price-default spirals that amplify an initial shock and help the model fit both national and cross-sectional moments better than a model without foreclosure. When calibrated to the recent bust, the model reveals that the amplification generated by foreclosures is significant: Ruined credit and choosey buyers account for 25.4 percent of the total decline in non-distressed prices and lender losses account for an additional 22.6 percent. For policy, we find that principal reduction is less cost effective than lender equity injections or introducing a single seller that holds foreclosures off the market until demand rebounds. We also show that policies that slow down the pace of foreclosures can be counterproductive.
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