Illiquidity and its Discontents: Trading Delays and Foreclosures in the Housing Market

This paper investigates the macroeconomic effects of search risk in the housing market. To do so, I introduce a tractable directed search model of housing with mul- tidimensional buyer and seller heterogeneity. I incorporate this framework in an in- complete markets macroeconomic model with long-term mortgages and equilibrium default. I show that search risk spills over into higher foreclosure risk by creating a debt overhang problem. Heavily indebted sellers post high selling prices, take a long time to sell, and frequently end up in foreclosure. As a result, search risk increases mortgage default premia and tightens credit constraints, thus exacerbating the debt overhang problem by making refinancing more difficult. This mechanism establishes a novel link between housing and mortgage markets based on the illiquidity of housing.