Your wife's mother has spirit and she is smart. After all, she outsmarted both you and the hospital. You took her keys so she had a new lock installed. The
hospital declared her competent, but your mother-in-law needs further diagnosis: she should be worked up by a neurologist to explore for dementia, a geriatric psychiatrist to check her mental well-being, and possibly a urologist.
With that said, you ask, "What is wrong with our mother?" You are not alone. Whether there is a diagnosis or not, many elders suffer from excessive attachment to a life which no longer exists. Since the Chinese earthquake, many elderly people are refusing to leave their caved-in homes. When their adult children come to get them, they beg to stay. "Just bring me food. I don't want to leave my home."
Old age often reveals so much about a person. In younger years when we are better looking and moving fast, our neuroses are more hidden. Now they are revealed. With her house condemned, perhaps your mother-in-law feels doomed. She tries to dispel the gloom and doom by hanging onto possessions. Disconnected from feeling good, she sits in her own waste. Your mother is afraid. What will happen to her when the officials come to evict her? Will they put her on the street or take her to a nursing home or the emergency room? Wherever it is, she will want your help.
At this point, when she wants help, there may be more possibility. Part of helping is an attitude. Over and over you tell her, "We are so sorry that you have to move. We love you. We want to help."Over and over, say, "We will try our best."
Another part of helping is elbow grease. She will need a place to live: adult foster care, senior housing, independent living, assisted living, an apartment in low-income housing. Wherever that is to be, move what fits from her condemned house into the smaller place. Let the family take what they want. Hold an estate sale for the rest. Whatever is left over, donate to charity. This may cause her feathers to fly, but she will settle down.
Then the new task begins: helping her connect to her new life. All the time, you have to say, "We know this is hard. You can do it. We love you."