How Do Foreclosures Exacerbate Housing Downturns?

Adam Guren, Tim McQuade

W13-8: The recent housing bust precipitated a wave of mortgage defaults, with over seven percent of the owner-occupied housing stock experiencing a foreclosure. This paper presents a model that shows how foreclosures can exacerbate a housing bust and delay the housing market.s recovery. By raising the ratio of sellers to buyers, by making buyers more selective, and by changing the composition of houses that sell, foreclosures freeze up the market for retail (non-foreclosure) sales and reduce both price and volume. Because negative equity is necessary for default, these general equilibrium e¤ects on prices can create price-default spirals that amplify an initial shock. To assess the magnitude of these channels, the model is calibrated to simulate the downturn. The ampli.cation channel is signi.cant. The model successfully explains aggregate and retail price declines, the foreclosure share of volume, and the number of foreclosures both nationwide and across MSAs. While the model can explain variation in sales across MSAs, it cannot account for the aggregate level of the volume decline, suggesting that other forces have reduced sales nationwide. The quantitative analysis implies that from 2007 to 2011 foreclosures exacerbated aggregate price declines by approximately 50 percent and declines in the prices of retail homes by approximately 30 percent.