The Problem of Artificially Inflated House Prices

Amidst all the breaking news today, you could be forgiven for not having time to notice the big WSJ article on kickbacks from property sellers to buyers - kickbacks which serve to overstate house-price indices and severely damage the balance sheets of mortgage lenders who end up lending on the basis of inflated valuations.

Lenders are being a bit more responsible these days when it comes to LTV ratios: they won't lend more than the property is worth. As a result, it seems that sellers and buyers are conspiring to pull the wool over the lenders' eyes by agreeing to a purchase price well above market. Here's the final anecdote from the WSJ story:

Another transaction that shows signs of price distortion is the sale of a home on Olen Mattingly Road in Avenue, Md. The two-story, 2,158-square-foot home, built within the past two years, was originally listed for sale in February 2005 for $635,000 but languished on the market for more than a year, according to local real-estate agents. The owner, builder Bennett Homes LLC, gradually reduced the price to $469,000 by March 2007. In May, however, the home sold for $600,000, far above the recent asking price. Vangie Williams, a real-estate agent who represented the buyers, says the sale involved a payment by the builder to an organization that collected fees for finding buyers. Officials of Bennett didn't respond to requests to comment.
A unit of Wells Fargo & Co. provided two loans to finance the purchase, the first for $479,800 and the second for up to $120,000, for a total of just under $600,000. That is about 28% more than the asking price for the home two months before the sale. A spokesman for Wells says the property was appraised at $615,000. He adds that Wells relies on "objective third-party appraisals in making all lending decisions. While we expect that appraised value [will] be close to market value, that may not always be the case."
The house recently was back on the market. The latest asking price: $499,000.

The problem here is that the entire mortgage industry is already overwhelmed with delinquencies and defaults. Everybody knows that a lender should do lots of due diligence on the valuation front before lending any money - the key is to lend not up to a maximum percentage of the purchase price, but rather up to a maximum percentage of the house's value. But during the property boom lenders were quite happy using purchase price as a proxy for valuation, and now they simply don't have the resources to switch back.