Real Estate and Loss Aversion : The Frontal Cortex

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Jonah Lehrer is a contributing editor at Wired. He's also written for The New Yorker, Seed, Nature, the Boston Globe and is a contributor to Radio Lab. He's the author of Proust Was A Neuroscientist. His new book is How We Decide.

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Real Estate and Loss Aversion

Posted on: December 13, 2007 10:24 AM, by Jonah Lehrer

Home sales are plummeting. In the Times, David Leonhardt focuses on Paramount, CA, site of the most precipitous drop in home sales in the country:

Just south of Los Angeles, there is a small city called Paramount where houses have all but stopped selling.
Since the summer, only about three homes a week -- including houses and condominiums -- have sold in Paramount. In the third quarter of this year, only 30 homes changed hands, down from 134 in the third quarter of last year.

That 78 percent drop is bigger than the decline in any other ZIP code in the country, according to an analysis that a research firm called DataQuick Information Systems did for me. The biggest declines can generally be found in moderate-income towns on the outskirts of major metropolitan areas, where adjustable-rate mortgages had become the norm. (In more affluent areas across the Northeast and California, the declines haven't been so big.)

In parts of Florida, Arizona and Nevada, home sales have fallen more than 60 percent over the last year. In several ZIP codes in California's Inland Empire, east of Los Angeles, the decline is greater than 70 percent.

Why are home sales falling so quickly? As the economist Austan Goolsbee notes, "Classical economics can't explain this behavior. That's because people who refuse to sell their houses for less than they paid for them are violating a cardinal rule of the market: stuff is worth what it's worth. It doesn't matter what you paid for it." In other words, home owners aren't acting like the rational agents in economics textbooks. Shocking, I know.

This is where loss aversion enters the picture. A 2001 study, "Loss Aversion and Seller Behavior: Evidence From the Housing Market," by Christopher Mayer and David Genesove demonstrated how our irrational sensitivity to losses distorts the real estate market, causing home owners to overvalue their homes. The two economists looked at condos in the Boston area from 1989 to 1992, when the average value of of such dwellings dropped 40 percent. If condo owners acted like rational agents, then a steep drop in the market price shouldn't lead to a cessation of selling. If they really to want to sell their home, then they should be willing to sell their home at the lower price, since that's what the market is currently offering. The potency of loss aversion, however, means that people are unwilling to sell their property at a loss. According to the 2001 study, condo owners who bought at the peak of the Boston market listed their properties for an average of 35 percent over the expected sale price. As a result, less than 30 percent of the condos sold within six months.

No doubt a similar process is at work in Paramount, CA. People despise losses so much that they will postpone the loss for as long as possible, even if it means flirting with foreclosure.

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Comments (12)

Query: What is the cause of loss aversion in a seller, assuming there is a single causative factor? In order to pass clear title to real estate, all of mortgages, liens and encumbrances must be satisfied or otherwise removed. In other words, if a seller owes more on the property than she can clear at settlement, why should she pay to sell the house? I think, quite the contrary, that this is an example of rational behavior by groups of sellers whose homes are oversecured. In this scenario, they simply can't afford sell, regardless of wish to do so.

Posted by: Alan | December 13, 2007 11:16 AM

I wonder if loss aversion is even one of the major factors. Since many buyers financed close to 100% of the purchase, they are upside down as soon as prices start dropping. On a $300,000 house -- probably modest in California terms -- even a 30% drop means a loss of nearly $100,000 on the sale. They still owe the full amount of the mortgage, and for many their primary asset was any equity they had in the house.

People who could not front a down payment cannot, short of bankruptcy, absorb that kind of "loss." While loss aversion is a very real thing (people don't sell stocks that are falling either) there are other factors here that play at least as big a role. They may be thinking they have no choice but to ride out the downturn in values and ride the market back up to equity.

Posted by: df | December 13, 2007 11:29 AM

So far we have only considered the seller's side of the market. We might also consider that since late 2006 over 200 mortgage lending operations have 'imploded.' Lending requirements have tightened, not only in the subprime markets, but also in alt-A's and prime markets. Thus, there are now markedly fewer qualified potential buyers, irrespective of the desires and aversions of potential sellers.

For potential sellers, the hope of riding the downturn in values up to equity may, for many, turn out to be a sentiment akin to the gamblers fallacy, as they continue to pay on a depreciating asset.

You also really have to look at the region and the type of housing, as well as sample size. Is it single-family dwelling, condominimum, semi-detached, etc.? I would caution against extrapolating too much from a study involving condos in a major metropolitan area during a past recession. If you look at the prices of condos in Manhattan, they've been rising.

The psychologist Daniel Kahnemann received the Nobel prize in economics a few years back. About time. Neoclassically trained economists tend to think like mathematicians, not social scientists. This is the voice of experience. "Economics exists to make astrology look respectable." J.K. Galbraith

Posted by: Alan | December 13, 2007 12:22 PM

If condo owners acted like rational agents, then a steep drop in the market price shouldn't lead to a cessation of selling. If they really to want to sell their home, then they should be willing to sell their home at the lower price, since that's what the market is currently offering

Sorry, but this analysis is wrong. You'll always see a drop in sales due to the wealth effect and income smoothing - a downward wealth shock reduces future consumption; upgrading to a better residence now costs more, while the status quo costs as much as it did before. Loss adversion may augment this effect, but even without it you'll still see a sales drop.

The main irrational behavior people are engaging in here is expecting their house may sell if they list it above the market price, but that only decreases sales for cases where the sellers would want to take the lower offer.

In the current case, the tightening up of credit supplies and the prospect of a bailout are probably much more important effects in falling sales. The credit crunch makes selling a poor choice for anybody who who isn't facing foreclosure, and for those who are, holding out for a potential bailout makes sense.

Posted by: MattXIV | December 13, 2007 12:45 PM

I was really surprised when I read on this very blog in August

http://scienceblogs.com/cortex/2007/08/the_neuroscience_of_market_bub.php

that the writer said: let's hope we've hit rock bottom.

When it seemed blindingly clear we hadn't even come close to rock bottom and won't for several years.

Prices come down much, much slower than they go up. Additional inventory will come on the market as people give up the idea they are going to get more than what they paid. Human nature.

Posted by: Mike Jenkins | December 13, 2007 12:50 PM

An examination of the prospect of bailout may be in order. A broad rationale for a bailout is that it may offer some mortgage servicers legal protection against investor suits, giving rise to an industry standard of modification. But some commentators are calling it too little, too late.

Consider also the risks of even a limited bailout. Modifying a loan may prolong the mess, and does nothing to eliminate the risk of default later on. The overall effect will be modest, and the inventory of foreclosures will rise in consequence, meaning more doward pressure on prices.

A recent working paper at the Boston Federal Reserve, entitled, "Subprime Outcomes, Risky Mortgages, Homeownership Experiences, and Foreclosures," sheds some light on what to expect. Those starting homeownership with a subprime loan find themselves in foreclosure almost 20 percent of the time, or about 6 times as frequently as with prime borrowers. One of the paper's conclusions was that house price appreciation plays a dominant role in generating foreclosures. This is right in line with what Matt XIV has written. As Mike wrote, people will ultimately have to come to terms with the idea that they are not getting out for more than was paid.

The authors of the paper attribute most of the dramatic rise in MA market foreclosures during 2006 and 2007 to the decline in house prices that began in the summer of 2005. How does this augur for the projected to be hundreds of billions worth of resets about to occur over the next 24 months? Where subprime lending fed the most housing growth, one would expect to see a continuing cycle of prices for quite some time.

Posted by: Alan | December 13, 2007 1:27 PM

I live in Michigan where it's pretty much the worst housing market in the country. People are putting on huge conventions to try and educate people on how not to lose their home to foreclosure.

I chalk it up to a few things:
1 - Too much new home construction. Everywhere you look in the state there are huge subdivisions going up with close to houses in each one. Why buy somebody else's old house when you could buy a new one?

2 - Mortgage rates are too low. People look at the all time low mortgage rates, and they think now is the time to buy buy buy! So they go buy a new home, move in and then try to sell their old house. That doesn't work anymore. Today the only safe thing to do is to sell your house, then go looking for a new one.

3 - Interest only loans, balloons, etc. Lots of young people were only expecting to be in their current houses for a few years, so they got sucked into these short term balloons or arms, or they took a major hit with an interest only loan and aren't building up any equity with their payments. Then they want to move to a new place, but have no equity for a down payment and they still owe the entire mortgage. When they can't pay, the bank forecloses. Either that or they have to sell their house at less than their mortgage value and get a loan to cover the difference.

I personally know 7 families who have already dealing with these exact problems, including some going through foreclosures. People are leaving the state in droves because our economy and housing market is in the gutter, only to find out it is happening in other states too.

Posted by: Dave | December 13, 2007 1:54 PM

Another problem is viewing a house in the same way that you view other assets. While the paper value of houses are dropping the utilitarian value of housing - shelter - does not decrease. The roof over your head is providing shelter as well as it did at the top of the market.

Posted by: gex | December 13, 2007 1:55 PM

One more thought to add to the mix. Another reason that people are so unwillingly to take a loss on real estate may be that, in today's economy, where so few people have any savings or any hope of significant pensions on retirement, the equity in their homes is their only hope of any income to retire on.

Posted by: chezjake | December 13, 2007 6:58 PM

Most of the value of a home lies in its function as a home, not as an investment. And if your home value drops, and especially when it's more than the average, your current home will tend to be a better one for living than whatever you could buy for the money. You'd need to put too much money down just to get a home as good as the one you already have. You would not sell a used car if all you could get with the funds you'd pool was another, slightly worse used car.

Posted by: Janne | December 13, 2007 11:25 PM

The article states quite clearly that those who really stand to lose are the sub-prime borrowers who bought at a particular time, and who now face an upward adjustment in the interest on their mortgage that they literally cannot afford (in the example given, the guy's monthly mortgage payment was about to more than double) and who now must sell in a market where they cannot come away with enough to pay off the outstanding balance on their no money down loan. I don't think their loss aversion is irrational at all.
I heard some expert on the radio the other day who said that in the case of foreclosure, banks actually lose more money (about 80,000 dollars on average) than the people who lose their home (I hesitate to call it an asset in this case because there is little or no equity). I was wondering if he meant the banks are losing future interest payments. Does anyone know?
As Janne says, most of the value of a home lies in its function as a home, to which I would add, especially for most of not all subprime borrowers. Maybe there are a few flippers in there, but my guess is that these are people who, like all people, need shelter and believe what every realtor wants you to believe: paying rent is throwing your money away; it's better to buy than to rent, etc. Which in fact is not true, as The Economist and others have proven.
But we're left with this: shelter is a basic need. It is sad to hear that the very inadequate bailout plan recently announced was met with such vehement and mean-spirited criticism from some prime borrowers, who don't see why sub-prime borrowers should be helped in any way at their expense. Maybe they'll see things a little differently when homeless people start camping at the top or the bottom of their hill or in their backyard.

Posted by: peggy | December 14, 2007 1:48 PM

most IF not all (not most of not all), excuse me.

Posted by: peggy | December 14, 2007 1:50 PM