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Selection, Leverage, and Default in the Mortgage Market

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  • Arpit Gupta
  • Christopher Hansman

Abstract

We ask whether the correlation between mortgage leverage and default is due to moral hazard (the causal effect of leverage) or adverse selection (ex ante risky borrowers choosing larger loans). We separate these information asymmetries using a natural experiment resulting from the contract structure of option adjustable-rate mortgages and unexpected 2008 divergence of indexes that determine rate adjustments. Our point estimates suggest that moral hazard is responsible for 40 of the correlation in our sample, while adverse selection explains 60. We calibrate a simple model to show that leverage regulation must weigh default prevention against distortions due to adverse selection.

Suggested Citation

  • Arpit Gupta & Christopher Hansman, 2022. "Selection, Leverage, and Default in the Mortgage Market," The Review of Financial Studies, Society for Financial Studies, vol. 35(2), pages 720-770.
    • Handle: RePEc:oup:rfinst:v:35:y:2022:i:2:p:720-770.
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    File URL: http://hdl.handle.net/10.1093/rfs/hhab052
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    Cited by:

    1. Billio, Monica & Dufour, Alfonso & Segato, Samuele & Varotto, Simone, 2023. "Complexity and the default risk of mortgage-backed securities," Journal of Banking & Finance, Elsevier, vol. 155(C).

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    More about this item

    JEL classification:

    • D14 - Microeconomics - - Household Behavior - - - Household Saving; Personal Finance
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design

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