Asset Bubbles and Supply Failures : Where are the Qualified Sellers?

We argue that, when a housing bubble bursts, the combination of high loan-to-value mortgages and costly foreclosures can inhibit house prices from quickly falling to their new equilibrium levels. The adjustment problem manifests itself, among other ways, in homeowners being unable to complete the sale of their houses at current market values. For some time, the resulting supply failure distorts the supply of houses offered for sale, inventories of houses listed for sale, and the relative prices of different quality houses. Public policies have been targeted mostly at maintaining house prices by propping up demand. Those policies exacerbate the problems associated with this supply failure and can result in substantial reduction of social welfare due to misallocation of resources. The model we develop suggests instead that public policy should focus on unwinding uneconomic contracts in order to enable house prices to fall quickly to their equilibrium levels. Such policies would enable more homeowners to sell their houses at then current market prices, restoring the normal turnover of the housing stock and housing mobility to families. Indeed, by returning a measure of liquidity such policies would, in the long term, contribute to the demand for housing