Illiquidity and its Discontents: Trading Delays and Foreclosures in the Housing Market

By Aaron Hedlind

http://d.repec.org/n?u=RePEc:umc:wpaper:1417&r=dge

This paper investigates the macroeconomic effects of search risk in the housing market. To do so, I introduce a tractable directed search model of housing with multidimensional buyer and seller heterogeneity. I incorporate this framework in an incomplete markets macroeconomic model with long-term mortgages and equilibrium default. I show that search risk spills over into higher foreclosure risk by creating a debt overhang problem. Heavily indebted sellers post high selling prices, take a long time to sell, and frequently end up in foreclosure. As a result, search risk increases mortgage default premia and tightens credit constraints, thus exacerbating the debt overhang problem by making refinancing more difficult. This mechanism establishes a novel link between housing and mortgage markets based on the illiquidity of housing.

The illiquidity of the house market, along with the high correlation of house prices with local income, has always made me wonder why homeownership is so much encouraged. This paper gives a further argument why homeownership is a poor investment vehicle. And this paper applies to the US, where house markets are remarkably liquid in international comparison.

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