Waves of Optimism: House Price History, Biased Expectations and Credit Cycles

Using the Michigan Survey of Consumers, I show that American households have heterogeneous expectations about the future of house prices, which largely depend upon the history of past house price realizations in the local area of residence. House price expectations are also systematically biased and inefficient, and as such inconsistent with even weak forms of the rational expectations hypothesis. In particular, house price forecasts display an extrapolative component: expectations are over-optimistic in good times and over-pessimistic in bad ones. This systematic bias matters because consumers make financial decisions on the basis of their house price beliefs. Exploiting an exogenous shift in housing sentiment I show that when individuals expect the value of their properties to rise, they borrow against the anticipated increase in home equity. One standard deviation increase in house price expectations changes the average leverage ratios on long-term fixed-rates mortgages by 6% of a standard deviation. The magnitude of this effect doubles when considering only home equity mortgages.