Indebted sellers, liquidity and mortgage standards

Abstract

The effects of households’ indebtedness on their house selling decisions, the implications of these decisions for default and the effects of policies intended to reduce the incentive to default are studied in a dynamic model with search in the housing market and defaultable long-term mortgages. In equilibrium, both sellers’ asking prices and time-to-sell increase with the relative size of their outstanding debt. For sellers in financial distress, this behavior results in a positive relationship between debt and their individual risk of default. Prices and time-to-sell determine both the liquidity of the housing market and the aggregate risk of default. As such they determine the extent of profitable lending by competitive lenders. Calibrated to the U.S. economy, the model also generates, as observed, positive correlations (i) across sellers of asking prices with loan-to-value ratios, and (ii) over time of both house prices and time-to-sell with mortgage loan-to-value ratios at mortgage origination. Policies aimed at reducing default may be counterproductive if they raise the value of mortgages and thus lower lending standards, ultimately increasing the rate of default and reducing aggregate welfare. We consider also the implications of these policies for the effects of aggregate shocks on house prices and the rate and severity of mortgage default.