By Steven K. Beckner

(MNI) – Mortgage lenders are “systematically” overvaluing homes on
which they are foreclosing, swelling inventories of “real-estate owned”
or REO properties, a pair of Cleveland Federal Reserve Bank economists
said in research released Thursday.

If foreclosed properties were valued at lower levels, there would
be more incentive for lenders to reach loan modification agreements with
their borrowers, and there would be less of an overhang of unsold homes
to depress the housing market, Thomas Fitzpatrick and Stephan Whitaker
argue in the Cleveland Fed’s latest “Economic Commentary.”

“Swelling REO inventories” are “costing lenders money and
contributing to neighborhood blight,” they write. “Yet lenders could
avoid taking on so much REO if they could more accurately estimate the
value of the homes they foreclose on, especially in weak housing
markets.”

“Correcting this apparent misunderstanding of the market could
speed the clearing of REO inventories, save lenders money, and help
stabilize housing markets,” they add.

Not only are repossessed properties bad for communities and the
economy, they are “expensive for lenders,” the Cleveland Fed staffers
write. “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.”

“These problems are worse in weak housing markets, where the supply
of housing exceeds the demand for it,” they say, adding that “in weak
markets, lenders may be better served by not taking properties into REO
in the first place, or minimizing the time properties spend in REO by
donating them to land banks.”

Yet foreclosures and REO inventories have ballooned because of “the
systematic overestimation of property values in weak housing markets by
appraisers, investors, and lenders,” they say. “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.”

Fitzpatrick and Whitaker analyzed home sales data from Cuyahoga
County, Ohio, the county seat of which is Cleveland, and “found signs
that appraisers, lenders, and investors could be routinely
overestimating the property values of foreclosed homes there.”

Their findings tend to support a “white paper” on housing policy
which Fed Chairman Ben Bernanke sent to Congress in January.

The economists offer three reasons why lenders may be overvaluing
foreclosed properties:

* “The first is that they may not actually be overvaluing property
at all, but rather placing the minimum bid knowing the property is not
worth it.”

The authors say “lenders might want to gain control at the auction
to get higher prices for the home later,” but they warn “this strategy
can work in the opposite direction. If a home is found to be
uninhabitable and beyond repair after the sheriff’s sale, the lender has
foregone any proceeds from another bidder.”

* Second, “lenders may be overvaluing properties because their
valuation methods — which they use because they work well in most
markets — don’t happen to work well in weak ones.”

* Third, there may be regulatory “incentives that encourage lenders
to overvalue foreclosed properties.”

“Doing so would allow them to shift accounting losses from their
loan portfolio to their REO portfolio,” they explain. “Solvency tests
and supervisors of financial institutions place less emphasis on REO
portfolios than on loan portfolios.”

Fitzpatrick and Whitaker write that “regardless of why it is
occurring, correcting the systematic overestimation of property values
in weak housing markets appears to be relatively simple and has large
potential ramifications.”

They maintain that “if lenders place more weight on simple property
characteristics — the age of the home and its location — in their
value estimates, they will more accurately price property in weak
housing markets.”

The result, they hope, would be more loan modifications to avoid
foreclosure in the first place.

The Cleveland Fed staffers argue that “more accurate pricing could
lower REO carrying costs in a few ways….”

“(L)enders could avoid taking on REO altogether by setting their
auction reserves lower and allowing others to purchase more properties
at auction,” they write. “Additionally, more accurate prices might help
lenders reduce the number of foreclosures they initiate by making more
loan modifications look sensible.”

“The more successful loan modifications the lender initiates, the
fewer homes that will end up in REO, and the lower the lender’s carrying
costs will be,” they continue. “But if lenders are overestimating the
value of weak-market property at foreclosure, then they are likely
overestimating the value of the same property when determining whether
to offer loan modifications through their net present-value
calculations.”

“If the current value of the property is overestimated, it is less
likely that a loan modification will be offered, and when one is
offered, it will be less generous than if the property’s value is not
overestimated,” they add.

Fitzpatrick and Whitaker also write that “more accurate pricing”
would help lenders lower their carrying costs by helping them “identify
the properties that have the least value early in the foreclosure
process. Knowing which properties aren’t worth holding onto will
facilitate their disposition to land banks, local governments, or
community development corporations seeking to remediate blight.”

** MNI Washington Bureau: 202-371-2121 **

[TOPICS: M$U$$$,MMUFE$,MGU$$$,MFU$$$]