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February 25, 2009

Are We Overestimating Foreclosures?

Catherine New
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President Obama’s housing plan, which will take effect on March 4, is aimed at two groups of homeowners. The first group simply cannot afford to make their mortgage payments and are in acute danger of foreclosure. The second includes homeowners who are current on their payments but who are unable to refinance in the face of high interest rates due to their homes’ decreased value.

“The nightmare scenario is that this second group of homeowners will all start abandoning their houses,” says Professor Eric Johnson. “But behavioral economics suggests that won’t happen so easily.”

“We need to know one fact: how many people will abandon their houses when that property is underwater. Standard economics makes a clear prediction that when your house is underwater, and you owe more than it’s worth on the market and that amount is more than it costs to move, you will abandon the house and accept a foreclosure.”

“But there are two effects in behavioral economics that suggest that won’t happen so easily,” Johnson continues. “The first is the endowment effect. People tend to value their own house above its market price.” Johnson cites a 1997 study by Senior Vice Dean Chris Mayer and David Genesove of MIT that analyzed the Boston condo market in the early 1990s. The study showed that a homeowner’s equity position determined his or her experience as a seller. Those with a high loan-to-value ratio set a higher reservation price, causing the home to take longer to sell. “Owners don’t want to sell at a loss. They have what we call a loss aversion,” Johnson says.

“Secondly, people weight present outcomes more than long-term benefits. Imagine making a choice between staying where you are and moving somewhere else. That somewhere else might be nice, but what do you have to do to get there? You have to pack up, pay movers and learn a new neighborhood. All those are upfront costs, while the benefits are long-term. People are impatient and weight present costs and benefits more, so they will walk away less often than we might think.”

Photo credit: Eric Hackathorn


by Shekhar Yadav | February 25, 2009 at 2:22 PM

This is interesting... I think the loss aversion also extends to the fact that foreclosure is giving up; it is in a way admitting I am incompetent and financially not strong. I think in most cases it hurts the ego, and people overlook financial hardship just to feel better about themselves.

by Kevin Kleen | February 26, 2009 at 8:20 AM

I think other biases which come into play are optimism bias and sunk cost effects. I can tell you from personal experience talking to distressed borrowers that very few make a decision to default before they run out of resources. The vast majority pay their mortgages until they can't.

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