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Researchers Use Modeling and Simulation to Study Problem of Strategic Defaults in the Housing Market

The real estate market nationwide faces severe challenges from foreclosures. There are difficult questions being asked about the best course of action for banks and governments to take to limit the damage caused by people defaulting on their mortgages.

Researchers at Old Dominion University are using modeling and simulation in an attempt to help solve this vexing economic problem. In a recently written paper, the answers they've found suggest a different course of action should be taken nationwide when it comes to properties in default.

Researchers Michael Seiler, professor of finance and Robert M. Stanton Chair of Real Estate and Economic Development, and Andy Collins, an assistant professor at ODU's Virginia Modeling, Analysis and Simulation Center used a model of 2,500 homes to try to predict how a flurry of homeowners defaulting on their mortgage would affect other homeowners who have not defaulted.

"The further and further underwater you get, the more it might make financial sense to walk away. The ultimate choice is a tradeoff between moral values and economics," Seiler said.

The model, built by master's student Marshall Gangel, suggests that the best course of action for a community troubled by mortgage defaults is to speed up the foreclosure process.

"The neighbor who is paying the mortgage finds out about their neighbor who isn't, and it creates something called the moral hazard problem," Seiler said. "The paying neighbor asks himself why he should continue paying his mortgage when his neighbor stopped paying a year ago and nothing bad has happened to him. It creates an incentive for people to do a bad behavior, one that's harmful to others in the market. This problem is quickly getting out of control and someone needs to step in."

Seiler said the average foreclosure in a judicial foreclosure state takes 5.8 months to work its way through the system.

"All the uncertainty, vagary and lengthening of the foreclosure process causes more chaos in the market. So our paper suggests the strongest influence that crushed the housing market is the delay in resolving the foreclosure. Get the home into the hands of a healthy buyer quickly, however painful the foreclosure process is. It's like taking off a Band-Aid. When a neighbor defaults, it's bad for me. But if the foreclosed home lingers, it's going to be horrible for me."

The agent-based model was set up so each of the 2,500 homes in the model would have its own set of rules - some would be in a more precarious financial situation than others, and some would feature owners more willing to keep paying a mortgage at all cost.

"You program the model at the micro level and let it run, and what you get are 'emergent behaviors.' Does the market collapse? Does it drop 25 percent? Is it able to recover?" Seiler said.

Seiler recently returned from presenting the paper "Exploring the Foreclosure Contagion Effect Using Agent-based Modeling," at the Massachusetts Institute of Technology. He's excited to extend this work to examine the "strategic foreclosure contagion effect" - meaning, the effect a foreclosure has on homeowners who might be able to meet their mortgage payments, but choose not to.

"There are researchers who study the spread of diseases like the bird flu and SARS," Seiler said. "We're interested in how fast this can physically spread throughout our society and potentially become a widespread epidemic, or pandemic. And we can use their models and say, instead of a virus, could this be a notion, a concept, a way of thinking?"

Fifty years ago it was verboten to miss mortgage payments, Seiler said. Studies now show that people are paying credit cards first, because they have the highest interest rate. "People think, 'No one's taking homes anyway, so I'll pay that when I get to it.' They're taking vacations before they're paying their mortgage. The whole market has gone nutty," Seiler said.

The researchers also are hoping to study how experts in real estate, whom they term "market mavens," and well-known people, whom they call "social connectors," affect the spread of this contagion.

"The key to solving the housing crisis is for home prices to go back up - or at least level off. That's easier said than done. In the meantime, we're wondering if home prices will come up faster than this contagion will spread, and cause a complete collapse of the market."

This article was posted on: December 3, 2010

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