While recent work has explored overoptimism in several markets already, including credit cards, payday loans and health-club contracts, overoptimism seems particularly relevant to understanding household behavior in mortgage markets. Households could have believed home prices would continue an inexorable rise. Households might have anticipated that they'd have lower expenses or be able to earn additional income over time. They also could have hoped interest rates would fall, facilitating mortgage refinancing or home resale before payments on their mortgages rose.
Lenders have complicated incentives in relation to borrowers' overoptimism. Lenders would wish to cultivate overoptimism to the extent that it increases demand for loans and decreases interest-rate sensitivity. To the extent that overoptimism increases delinquency and default rates, lenders would want to disabuse borrowers of it. Mortgage lenders' incentives to counteract borrowers' overoptimism shrunk over the last decade, as lenders also began to believe house prices would continue to rise, and as they increasingly sold off their mortgage default risk using mortgage-backed securities.
The resulting costs for households are large. Moving costs for families amount to 10% of the transaction price of a house. Delinquencies and foreclosures compromise the credit ratings of borrowers. And inefficiencies may be a result: either non-overoptimistic mortgage borrowers should have owned instead of overoptimistic borrowers, or new homes bought by overoptimistic borrowers should not have been built in the first place.
These thoughts lead of course to the question, "So what?"
Decisions about what to do right now will be influenced by a host of factors, election-year politics not least among them. Government or NGO payments for some homeowners of a bit of mortgage principal might suffice to keep them in their homes. Encouraging financial institutions to renegotiate some mortgages might also help. For the future, the mortgage application process should be required to entail detailed analysis of cash flow for prospective home buyers, to help them think through-- less overoptimstically, and more clear-sightedly--the long path of payments that will gradually turn them into full owners of their homes.