Foreclosures and House Prices
The empirical evidence from the last decade suggests that sizeable increases in housing defaults can be the result of either income shocks (recession 2001) or changes in the market value of the house (2005-2007 period). The objective of this paper is to understand the double feedback mechanism between foreclosures and house prices. To understand the importance of this channel we develop an equilibrium theory of housing default. Housing investment requires a downpayment and long-term mortgage financing. However, at any point in time homeowners can default in their obligations, but they loose the property. The stationary version of the model is capable of generating house price increases that are consistent with the average capital gains realized between 1990 and 2005. The model can also rationalize declines in house prices that are consistent with the observed counterpart. The baseline model also replicates the observed decline in the user cost of housing defined as the ratio between the price index for rental property and owner-occupied housing that models based on arbitrage conditions are incapable of replicating.
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