Foreclosures, House Prices, and the Real Economy

• Date: 01 December 2015
• Published date: 01 December 2015
• DOI: http://doi.org/10.1111/jofi.12310

THE JOURNAL OF FINANCE •VOL. LXX, NO. 6 •DECEMBER 2015

Foreclosures, House Prices, and the Real

Economy

ATIF MIAN, AMIR SUFI, and FRANCESCO TREBBI∗

ABSTRACT

From 2007 to 2009, states without a judicial requirement for foreclosures were twice

as likely to foreclose on delinquent homeowners. Analysis of borders of states with

differing foreclosure laws reveals a discrete jump in foreclosure propensity as one

enters nonjudicial states. Using state judicial requirement as an instrument for fore-

closures, we show that foreclosures led to a large decline in house prices, residential

investment, and consumer demand from 2007 to 2009. As foreclosures subsided from

2011 to 2013, the foreclosure rates in nonjudicial and judicial requirement states

converged and we find some evidence of a stronger recovery in nonjudicial states.

THE POST-2006 COLLAPSE IN THE U.S. housing market led to a 35% drop in house

prices and an increase in mortgage delinquency rate that reached over 10% in

2009. Mortgage contracts give lenders the right to foreclose on a home if the

homeowner defaults on his payment obligations. When a major shock hits the

economy and millions of homeowners simultaneously default, theory suggests

that the fire sale of foreclosed homes could lead to a further reduction in house

prices, threatening real activity, such as residential investment and consumer

demand.1

As Figure 1shows, the default rate on household debt and foreclosures sky-

rocketed from 2006 to 2009, before falling sharply from 2010 to 2013. In this

paper we investigate the effect of this unprecedented foreclosure wave on house

prices and real activity. Shedding light on this question can help us better un-

derstand the transmission and amplification of financial shocks into the real

∗Mian is with Princeton University and NBER. Sufi is with the University of Chicago Booth

School of Business and NBER. Trebbi is with the University of British Columbia, CIFAR, and

NBER. We thank Paul Beaudry; John Cochrane; Kris Gerardi; Christopher James; Francisco

Perez-Gonzalez; Jesse Shapiro; Jeremy Stein; Robert Vishny;Susan Woodward; Kenneth Singleton

(the Editor); an anonymous Associate Editor; two anonymous referees; and seminar participants

at Boston College, Boston University, MIT, the NBER Summer Institute, Stanford University, the

University of British Columbia, the University of Chicago, Yale,and UCLA for comments. We also

thank the National Science Foundation and the Initiative on Global Markets at the University

of Chicago Booth School of Business for funding. Filipe Lacerda and Mauricio Larrain provided

excellent research assistance. The Internet Appendix may be found in the online version of this

article.

1Models that emphasize amplification of shocks from the leverage-induced forced sale of durable

goods include Shleifer and Vishny (1992), Kiyotaki and Moore (1997), Krishnamurthy (2003,2010),

and Lorenzoni (2008).

DOI: 10.1111/jofi.12310

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1

1.5

2

2.5

3

Foreclosures, millions

.02

.04

.06

.08

.1

Household default rate

1993 1998 2003 2008 2013

Household default rate, [left axis]

Foreclosures, millions [ri

g

ht axis]

Figure 1. Household default rate and foreclosures. This figure shows aggregate foreclosures

in the United States from RealtyTrac.com and the household default rate from Equifax.

economy.However, isolating the causal effect of foreclosures is difficult because

of omitted variables and reverse causality. The latter effect is especially impor-

tant: homeowner, will only allow a foreclosure to occur if they are underwater

on their mortgage. As a result, house price declines will be strongly correlated

with foreclosures even if foreclosures have no direct effect on house prices.

To estimate the effect of foreclosures on economic outcomes, we take advan-

tage of differences in state laws in the foreclosure process. In particular, some

states require that a foreclosed sale take place through the courts (judicial

foreclosure states). In these states, a lender must sue a borrower in court be-

fore conducting an auction to sell the property. Other states do not have such

a requirement (nonjudicial foreclosure states) and give lenders the automatic

right to sell the delinquent property after providing only a notice of sale to the

borrower. As first highlighted in the economics literature by Pence (2006), the

21 states that require judicial foreclosure impose substantial costs and time on

lenders seeking to foreclose on a house.

Do legal differences in foreclosure laws affect the propensity to foreclose on

a home? We find that the answer is a resounding yes. For example, during

the heart of the foreclosure crisis in 2008 and 2009, a delinquent homeowner

in a nonjudicial foreclosure state was more than twice as likely to experience

foreclosure on a delinquent home, with 1.6 foreclosures per homeowner with

a mortgage in judicial foreclosure states versus 3.6 in nonjudicial foreclosure

states.

Zip code-level analysis around bordering states that differ in their foreclosure

laws shows a discontinuous jump in foreclosure propensity as one moves from

Foreclosures, House Prices, and the Real Economy 2589

a judicial to nonjudicial state. A similar jump is observed when we look at

listings of new houses for sale, and the higher foreclosure propensity persists

until 2010. Thus, differences in state laws are associated with a large increase

in foreclosure rates that translates into greater housing supply on the market.

The strong correlation between state foreclosure laws and foreclosure propen-

sity suggests that state laws may be used as an instrument for foreclosures. But

what drives the difference in state foreclosure laws? It is possible that differ-

ences in state foreclosure laws are spuriously correlated with state attributes

that independently influence foreclosure propensity.

Ghent (2012, p. 2) performs an in-depth analysis of the history of state foreclo-

sure laws and concludes that “there do not seem to be clear economic reasons for

the different patterns of development in America’s mortgage laws.” She traces

differences in state mortgage laws to “path-dependent quirks.” Consistent with

Ghent’s observations, we find that state foreclosure laws are orthogonal to a

wide range of state-specific economic attributes.

State-level analysis shows that there are no significant differences between

judicial and nonjudicial states in terms of mortgage defaults, house price

growth from 2002 to 2005, the level of house prices in 2005, leverage or debt-

to-income growth from 2002 to 2005, the fraction of subprime mortgages, mort-

gage interest rates from 2002 to 2005, loan-to-value ratios from 2002 to 2005,

household income, the precrisis unemployment rate, racial mix, poverty rate,

or education level. Similarly, the sharp discontinuity in the zip code-level anal-

ysis exists only in foreclosure propensity: there is no equivalent jump in other

zip code-level attributes including credit score, income, race, education, default

rate, or house price growth from 2002 to 2005.2

Given the strong effect of the judicial foreclosure requirement on foreclosures

and the abundant evidence that states with and without this requirement are

otherwise similar, we use state foreclosure laws as an instrument to estimate

the effect of foreclosures on house prices. We find that foreclosures have a

strong effect on house prices. Moving from the median to the 90th percentile

of the foreclosure per homeowner distribution leads to eight-percentage-point

lower house price growth from 2007 to 2009. A back-of-the-envelope calculation

suggests that the foreclosure-induced increase in supply of houses can plausi-

bly explain the entire effect of foreclosures on house prices. For example, our

estimates imply that a foreclosure-induced increase of 10% in the supply of

houses in nonjudicial states decreased house prices by four percentage points.

Theoretical models predicting a supply-induced price effect of foreclosures

often rely on temporary market displacement where natural buyers of an asset

face limits in their ability to purchase homes, a phenomenon known as a fire

sale.3In these models, a price rebound can occur if the flow of houses hitting

the market slows. A price rebound could also occur if limits on the ability

2We also analyze at length any ex ante differences in availability of credit between judicial and

nonjudicial states, and find no significant differences during the credit boom years of 2001–2005.

See Section III for further discussion.

3Shleifer and Vishny (1992), Krishnamurthy (2003), and Lorenzoni (2008) emphasize that the

negative effect of asset sales on prices is amplified when the economy is weak and potential buyers