Housing and Liquidity

Coinciding with the start of the housing boom were large increases in home-equity lending and loan-to-equity ratios. We study this in models where housing bears a liquidity premium because it collateralizes loans. Even with fundamentals constant, since liquidity depends on beliefs, self-fulfilling prophecies allow prices to be cyclic, chaotic or stochastic. With changing fundamentals -- financial innovation -- we can account for half of the empirical price boom, suggesting there may well be room for self-fulfilling prophecies. Since liquidity premia are nonmonotone in loan-to-equity ratios, continuing financial innovation generates a price boom and bust. Finally, we study the impact of monetary policy. (Copyright: Elsevier)