I was struck by a string of articles around the country that summed up pretty well how the foreclosure crisis has spread throughout the housing market:

The Wall Street Journal: Number of Foreclosed Homes Keeps Rising

The Chicago Tribune: Break for sellers: Banks settle for less

The Arizona Daily Star: Foreclosures push down your home's selling price

First, the number of foreclosed homes continues to rise.  Foreclosures are expensive for banks, which lose money because they have to pay court costs and associated fees to foreclose on a home, and lose money because they typically sell the home (if they can) for less than the mortgage amount.

Second, banks realize that foreclosing on homes is bad for them, too, so they start to make deals with homeowners in trouble.  Those deals might include reworking a loan, like reducing the principal or changing the interest rate, or they might involve a short sale, where the lender agrees to take whatever the homeowner can sell the home for, even if it’s less than the mortgage amount.

Third, foreclosures, which result in the banks selling homes for less than what they’re worth, or short sales, which do the same, push down the “market value” of homes in a given area.  Market value is typically determined by the price of recently sold comparable homes within a 1-mile radius.

According to the Arizona Daily Star article, “The rising number of foreclosures is reducing property values in a possibly unprecedented way. Not only are foreclosed properties flooding the market, but they are also becoming the only standard of comparison for other homes sold in some areas.”

Lower home values make it even harder for families in trouble to sell their homes, and put even more downward pressure on prices – which reduces the price banks can charge for foreclosed homes or homeowners can charge for short sales.

According to the Wall Street Journal article, “With home prices falling, "holding the assets means further losses," said Mark Fleming, chief economist for First American CoreLogic. Some lenders now are cutting prices as often as every 20 days on homes that aren't selling, said David McCarthy, chief executive officer of Integrated Asset Services LLC, a Denver-based company that helps banks value and sell REO homes.”

Yet the process may be a necessary evil – an unavoidable path out of the housing market downturn.  As prices drop, more buyers enter the market, which reduces the inventory of unsold homes.  As the inventory of unsold homes shrinks, supply becomes more closely aligned with demand.  Once supply and demand are aligned again, prices will rise to a “normal” level and the market will have rebounded. 

So while foreclosures and short sales may increase the pain of the downturn in the short term, they will also decrease the length of the downturn, which is better for us all in the long run.