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Systemic Risk and the Refinancing Ratchet Effect

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  • Amir E. Khandani

    ()
    (MIT Sloan School of Management and Laboratory for Financial Engineering)

  • Andrew W. Lo

    ()
    (MIT Sloan School of Management and Laboratory for Financial Engineering)

  • Robert C. Merton

    ()
    (Harvard Business School, Finance Unit)

Abstract

The confluence of three trends in the U.S. residential housing market-rising home prices, declining interest rates, and near-frictionless refinancing opportunities-led to vastly increased systemic risk in the financial system. Individually, each of these trends is benign, but when they occur simultaneously, as they did over the past decade, they impose an unintentional synchronization of homeowner leverage. This synchronization, coupled with the indivisibility of residential real estate that prevents homeowners from deleveraging when property values decline and homeowner equity deteriorates, conspire to create a "ratchet" effect in which homeowner leverage is maintained during good times without the ability to decrease leverage during bad times. If refinancing-facilitated homeowner-equity extraction is sufficiently widespread-as it was during the years leading up to the peak of the U.S. residential real-estate market-the inadvertent coordination of leverage during a market rise implies higher correlation of defaults during a market drop. To measure the systemic impact of this ratchet effect, we simulate the U.S. housing market with and without equity extractions, and estimate the losses absorbed by mortgage lenders by valuing the embedded put-option in non-recourse mortgages. Our simulations generate loss estimates of $1.5 trillion from June 2006 to December 2008 under historical market conditions, compared to simulated losses of $280 billion in the absence of equity extractions.

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Bibliographic Info

Paper provided by Harvard Business School in its series Harvard Business School Working Papers with number 10-023.

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Length: 69 pages
Date of creation: Sep 2009
Date of revision: Jul 2010
Handle: RePEc:hbs:wpaper:10-023

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Keywords: Risk; Financial Crisis; Household Finance; Real Estate; Subprime;

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Cited by:
  1. Buiter, Willem H., 2010. "Housing wealth isn't wealth," Economics - The Open-Access, Open-Assessment E-Journal, Kiel Institute for the World Economy, vol. 4(22), pages 1-29.
  2. Manuel Adelino & Antoinette Schoar & Felipe Severino, 2012. "Credit Supply and House Prices: Evidence from Mortgage Market Segmentation," NBER Working Papers 17832, National Bureau of Economic Research, Inc.
  3. Campbell, John Y., 2012. "Mortgage Market Design," Scholarly Articles 9887618, Harvard University Department of Economics.
  4. John Y. Campbell & Howell E. Jackson & Brigitte C. Madrian & Peter Tufano, 2011. "Consumer Financial Protection," Journal of Economic Perspectives, American Economic Association, American Economic Association, vol. 25(1), pages 91-114, Winter.
  5. Pol, Eduardo, 2012. "The preponderant causes of the USA banking crisis 2007–08," Journal of Behavioral and Experimental Economics (formerly The Journal of Socio-Economics), Elsevier, Elsevier, vol. 41(5), pages 519-528.
  6. Ebrahim, M. Shahid & Shackleton, Mark B. & Wojakowski, Rafal M., 2011. "Participating mortgages and the efficiency of financial intermediation," Journal of Banking & Finance, Elsevier, Elsevier, vol. 35(11), pages 3042-3054, November.
  7. Ebner, André, 2013. "A micro view on home equity withdrawal and its determinants: Evidence from Dutch households," Journal of Housing Economics, Elsevier, Elsevier, vol. 22(4), pages 321-337.
  8. Guharay, Samar K. & Thakur, Gaurav S. & Goodman, Fred J. & Rosen, Scott L. & Houser, Daniel, 2013. "Analysis of non-stationary dynamics in the financial system," Economics Letters, Elsevier, Elsevier, vol. 121(3), pages 454-457.
  9. Huang, MeiChi, 2014. "Bubble-like housing boom–bust cycles: Evidence from the predictive power of households’ expectations," The Quarterly Review of Economics and Finance, Elsevier, Elsevier, vol. 54(1), pages 2-16.

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