The Fed calls it an “apparent misunderstanding.” Whatever term you prefer, a new Cleveland Fed study makes one thing clear: lenders are still overstating home values. The study focuses on real-estate-owned or REO inventory, which covers properties that are now owned by lenders.
We analyzed sales data from Cuyahoga County, Ohio, and found signs that appraisers, lenders, and investors could be routinely overestimating the property values of foreclosed homes there. We suggest some simple identifiers that can help lenders better estimate home values in weak housing markets. And though we have focused on one county, we believe the situation could be the same in other places. The factors we identify as possible causes of overestimation in Cuyahoga County are likely to be found in many other weak housing markets around the country.
The two Fed economists who wrote the report identify an array of reasons for such overvaluations, ranging from the perfectly innocent to the potentially dodgy:
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. The evidence supports this explanation, since it is not only lenders that overestimate the value of properties acquired in the sheriff’s sale, but all parties, including federal agencies and investors. Proper valuation methods would substantially discount the appraised value of homes in weak markets, bringing the estimates of value more in line with what the property will sell for on the open market. It is important to remember that lenders usually cannot legally enter the home and inspect the interior prior to foreclosure, which would prevent them from detecting hidden defects. But even when they are allowed to inspect the interior, it may not be feasible to inspect each property prior to foreclosure, given the number of foreclosures initiated every year.
Finally, there may be 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. Solvency tests and supervisors of financial institutions place less emphasis on REO portfolios than on loan portfolios. This is a function of banks having relatively small REO portfolios in normal times, but always having an active loan portfolio that can be analyzed.