Here are two theories that might help explain it and our conclusions.
If you think the real estate market will be filled more with foreclosures, then this business professor from Columbia University might change your view. Eric Johnson spoke with CNNMoney.com stating that buyers won’t easily walk away from their houses for the following two reasons:
First, through the endowment effect, people tend to value their own house more than its market price and owners prefer to be risk averse and refuse to sell at a loss.
Second, people are more affected by immediate results of their actions rather than the long term effects. He adds, “Walking away involves upfront expenditures of time, money and effort, while the benefits of walking away are back-loaded. People are impatient and weight present costs and benefits more, so they will walk away less often than we might think.”
Sounds plausible? Here’s what we found out more about Johnson’s arguments.
The endowment effect has been used for years to dispute some claims by rational economists about fair allocations in the market. The best and most popular example is the mug and chocolate example. When select students were given a mug and they’ve owned it for quite some time, they’d obstinate about exchanging it for a bar of chocolate.
Likewise, in Johnson’s explanation, houses possess sentimental value and “some” sellers would prefer to hang on for awhile until the market rebounds. This is best explained by Hersh Shefrin of Santa Clara University. In a study last year, he concludes, “In a normal housing market, people value their own houses more than is justified by what the market will pay (often about 12% over the market price). During a market downturn, the normal homeowner tries to sell their house for an average of 33% over market value.”
But take note, this only occurs because generally, homeowners can be classified as inexperienced traders. In another study by University of Chicago economics professor John A. List, he found out that “consumers with intense market experience behave largely in accordance with neoclassical predictions. The pattern of results indicates that learning primarily occurs on the sell side of the market: agents with intense market experience are more willing to part with their entitlements than lesser-experienced agents.” To put it simply, List is indicating that once market participants get to understand their role in the market, they will be eliminating the endowment effect in their minds.
But how does this explain the latest findings of the Mortgage Bankers Association that state the percentage of loans on which foreclosure actions that were started in the last quarter of 2008 tied the record set in the first quarter of the same year? The recession has influenced homeowners’ decisions to give in to foreclosure after all.
On the other hand, we must say that the endowment effect is not only the reason why some foreclosures are halted. In fact, it may have influenced it only minimally. Fannie Mae and Freddie Mac have announced their foreclosure prevention plans. Mortgage servicers are also awaiting Obama’s cost matching for their loan modifications. People may not just walk out of their homes since they value it so much but also because the government is artificially affecting the market.
The second reason – short-run costs vs. long-term effects, is more evident among those middle and low earners. It must also be added that even foreclosure proceedings are taking a longer time to finish and even servicers are burdened by the costs.