Association for Public Policy Analysis & Management

In this paper we study whether borrowers who overpaid for their house, are more likely to default later on, ceteris paribus. The occurrence of financial crisis in 2008 has seriously challenged the practice of using appraisals to safeguard collateral value. Here we instead use several measures of independent model-based valuations, against which we compare the purchase price. We demonstrate that compared to these valuations, borrowers who overpay are indeed monotonically more likely to experience serious default later on. Further we show that even if these loans are performing fine, unsurprisingly the borrowers eventually realize less gain when selling the house later on, controlling for the local house appreciation trend. This implies that these model-based valuations, while by methodological design are not completely removed from the general rising or declining price trend, can still detect these most egregiously inflated bubbles, and thus serve as a useful yardstick in prudential lending, which in the end not only help the lender and GSE, but also benefit the borrowers in the long run; otherwise, they either miserably default more, or if not default, receive less wealth accumulation from owning this overpaid house.