The ability of Dutch foreclosure auctions in maximizing seller revenue Why Dutch foreclosure auction prices fall short of the market price Martijn Duijster 0475211 Group 2 Finance, semester 2, 2013-2014 17-7-2014 Bachelor thesis Economics and Business - specialization Finance and Organization Sander Onderstal Faculty of Economics and Business University of Amsterdam Index Abstract 3 1. Introduction 3 2. Dutch real estate auctions 4 3. Literature review 6 3.1. Types of auctions 6 3.2. The revenue equivalence results 8 3.3. Violations of the revenue equivalence result assumption 8 3.3.1. Information asymmetry 9 3.3.2. Competition 10 3.3.3. Bidder affiliation and the winner’s curse 11 4. Hypotheses 12 5. Research method 13 6. Results 15 6.1.. Explanation of the results 17 6.1.1. Information asymmetry 17 6.1.2. Competition 18 6.1.3 Solutions to improve competition 18 6.1.4. Transaction costs 19 6.1.5 Conflicts of interest between seller and owner 21 7. Conclusion 22 References 24 Appendices 26 2 Abstract The revenues in Dutch foreclosure auctions are compared to the market values of the properties. The discount rate is calculated which states the difference between the auction price and the market price. Foreclosure auctions in the Netherlands fail to receive an auction price close to the market price; the average discount rate with auction cost included in the auction price is about 20% and the discount rate when auction costs are excluded is about 27%. Asymmetric information, lack of competition, transaction costs and conflicts of interest may be attributable to this price gap. 1. Introduction When homeowners fail to pay their mortgages the mortgagee can put the property up for auction in a final effort to reclaim the loan by selling it at a foreclosure auction. For the past years Dutch foreclosure auctions have been the subject of public debate. According to a letter from Ivo Opstelten (2014), the Dutch Minister of Security and Justice, complaints have been made by organizations such as the Dutch homeowners association (Vereniging Eigen Huis, VEH) and the Dutch realtors organization (Nederlandse Vereniging van Makelaars, NVM) that properties on auction do not receive a ‘fair’ price resulting in leaving homeowners with a residual debt after foreclosure. After receiving wide spread media attention, political debates have led to a legislative proposal by the Minister that would alter the current proceedings of foreclosure auctions by making it more transparent through online bidding and transferring risks from buyers to sellers. The difference between the auction price and the private sale price is commonly referred to as the foreclosure discount (Campbell, Giglio and Pathak, 2009). The goals of this thesis are to determine the discount rates and identifying the causes for these discount rates by analysing the Dutch foreclosure auctions and explain its strengths and weaknesses. The suspicion of the Dutch government and the Dutch competition authority (Nederlandse Mededingingsautoriteit, NMa now known as ACM) (2013) of the auction price being far below market value is tested by calculating the discount rate (the difference between market price and auction price as a percentage of the market price) for 53 auctioned properties. The discount is often attributed to a lack of information about the property and real estate traders forming cartels as concluded by the NMa (2013). The claim that a lack of information would increase the discount rate is tested by comparing the discount rates of properties with the possibility of inspection to those without this possibility. 3 The remainder of this thesis is organized as follows. In section 2 a description of the Dutch real estate auctions is given that explains the circumstances under which the auction price is realised. Next in section 3 the literature is reviewed in which basic auction theory is explored and the models are analysed leading to the revenue equivalence result and circumstances under which the assumptions of the revenue equivalence are violated are reviewed. The hypotheses for testing the research questions are presented in section 4. In section 5 the research method is outlined and the results of testing the hypotheses are presented in section 6 followed by a discussion of the possible causes for the results. I conclude in section 7 and discuss policies that may improve the system of Dutch foreclosure auctions. 2. Dutch real estate auctions Real estate auctions in The Netherlands are divided amongst 17 regional auction houses, 16 of which employ the same terms and conditions, the AVVE 2006. The First Amsterdam Real Estate Auction slightly differs in its auctions methods used with the main difference being that each auctioned object is supervised by a real estate agent in order to provide information to the buyers. The following section elaborates the various aspects of the Dutch auction process with the goal of understanding its strengths and weaknesses in setting the optimal auction price from the sellers’ point of view. Each auction is organised and executed by a notary with the help of an auctioneer and a secretary. The notary provides information regarding the auction and the bidders in the auction room have the possibility to ask questions which are mostly related to financial details and the state of the object. In addition to bidding in the auction house, all auction houses provide the possibility of bidding online since June 2014. An audio stream keeps the online bidders informed about the course of the auction and with the press of a button one can be the new owner of a house. Bidders at a real estate auction do not have the same rights as they would have in a private sale. All bids made are unconditional, irrevocable and without any reservation (AVVE, 2006). Consumer rights are well protected within Dutch law, but it would be impossible to grant these rights in auction, such as the right to cancel the sale within three days or the seller being held accountable for non-mentioned defects as they would both undermine the workings of the auction. 4 Buyers must provide identification and a declaration of their financial solvency by their bank or a bank guarantee of 15% of the auction price. Within 6 days a 15% deposit and within 6 weeks the remaining sum must be transferred to the notary. These conditions may vary at the discretion of the notary. A liquidity check ensures the sale will go through, avoiding payment problems from the buyers side. The seller of the object has the right to award or reject the sale after the auction. Dependent on the auction price the mortgagee or selling party can make the decision whether or not to go through with the sale so that in the event that they find the sale price too low the transaction is cancelled. The auction method of the Dutch real estate auction is a combination of an English auction with a premium followed by a Dutch auction. The English- or ascending bid auction starts out with the auctioneer asking for an opening bid. After the opening bid others may overbid, increasing the price until there are no more contestants and the hammer sounds closing first part of the auction. The highest bidder registers at the notary and the second part of the auction begins. In the Dutch or descending-bid auction the auctioneer sets off at a high price gradually lowering until someone accepts the price by calling ‘mine’ or alternatively the price drops to the level of the bid of the English auction causing the highest bidder of the first part to have won the auction. The winner of the English auction receives a premium for having the highest bid in order to stimulate bidders. The premium amounts to 1% of the highest bid in the ascending-bid phase. This premium is paid by the winner of the second part of the auction unless there are no bids or both bids come from the same person causing it to be cancelled. The organisation of these auctions can be a very costly affair. Typical auction costs vary between €5,000 and €15,000 per object. These consist of the actual costs made for organizing the auction and overdue payments from the former owner. An example of these cost is provided in the appendix and a listing from AVVE 2006 is stated below. 1) Real estate transfer tax 2) The notary fees 3) The bid premium 4) Costs of cadastral investigation and registration changing 5) Costs of cancellation of mortgage registration 6) Costs of advertisement, auctioneers fee and room rental 5 7) Other cost incurred in preparation and organization of the auction 8) Costs due according to specific object’s terms and condition 9) Costs of evacuation of the object The Dutch competition authority (NMa, now known as ACM) has fined real estate traders for collusion by making price agreements. In 2011 fourteen traders have been fined a total sum of 6,3 million euros and in 2013 another 65 traders were fined a total sum of 6,4 million euros. It is therefore safe to assume collusion took place in the Dutch real estate auctions with the effect of bringing down the auction prices. The NMa attributes the manipulation of real estate auctions to a limited number of bidders and few outsiders because of the risks involved in execution auctions. Buyers have limited options to inspect the property before the auction and uncertainty over possibility of it being rented out. 3. Literature review This chapter will review basic auction theory. Section 3.1 sets forth four commonly used auction models together with the Amsterdam auction. Section 3.2 shows that under some conditions these basic models yield the same expected revenue, this outcome is known as the revenue equivalence result.