How Do Foreclosures Exacerbate Housing Downturns?

We present a dynamic search model in which foreclosures exacerbate housing busts and delay the housing market;s recovery. By eroding lender equity, destroying the credit of potential buyers, and making buyers more selective, foreclosures freeze the market for non-foreclosures can cause price-default spirals that amplify an initial shock. To quantitatively asses these channels, the model is calibrated to the recent bust. The amplification is significant: ruined credit and choosey buyers account for 22.5 percent of the total decline in non-distressed prices and lender losses account for an additional 30 percent. We use our model to evaluate foreclosure mitigation policies and find that payment reduction is quite effective, but creating a single seller of foreclosures that holds them off the market until demand picks up is the most effective policy. Policies that slow down the pace of foreclosures can be counterproductive.