March 15, 2012 10:26 pm

Banks overbid in home foreclosure auctions

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US banks are systematically overvaluing some houses they foreclose on, increasing their own losses and causing families to needlessly lose their homes, according to research by the Federal Reserve Bank of Cleveland.

Banks suffered much bigger losses on properties they kept after a foreclosure auction – a legal requirement in the state of Ohio – than investors or federal agencies in the same position. Their losses were especially large on older, cheaper homes, suggesting a failure in their automatic valuation models.

“We just found these amazingly large discrepancies between what banks paid at sheriff’s sales and what they got on sale out of [foreclosure],” said Stephan Whitaker, a research economist at the Cleveland Fed.

The research suggests banks could reduce the number of foreclosures by improving their estimates of what such homes will be worth. If their estimate of foreclosure value is lower, banks may choose to offer a loan modification to a struggling borrower instead, letting them stay in their house.

A pick-up in the depressed housing market is essential for a strong recovery in the US economy, and the Obama administration has put a huge effort into promoting loan modifications and getting banks to rent out foreclosed homes – all with limited success. The Cleveland Fed research suggests that simple changes to bank valuation models could make a difference.

“The thing that really jumps out at me is the indirect implications for loan modifications,” said Tom Fitzpatrick, the other Cleveland Fed economist behind the research. “The higher the lender thinks that the value of a home is, the less likely they are to offer a modification.”

The research looked at foreclosures in Cleveland, Ohio, which was hit badly in the housing crash. In Ohio a home entering foreclosure is auctioned by the local sheriff, and the lending bank can bid to keep it for later sale, or let an investor buy it instead. It is usually not possible to inspect inside before the auction.

The researchers found that from 2006 to 2011 banks suffered an average loss of 42 per cent compared with the foreclosure auction price when they eventually sold, whereas federal agencies lost 30 per cent and private investors lost 26.5 per cent.

Mr Fitzpatrick suggests three possible explanations. Banks may just be bidding high, knowing that the house is worth less, so they can manage the sale themselves. But he says: “I think there is more evidence to suggest that their valuation methods are not working very well in distressed portfolios.”

A final explanation is that banks may bid high to shift accounting losses from their regular loan books – which are closely scrutinised by regulators – to their less-watched foreclosure portfolios.

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