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Systemic Risk and the Refinancing Ratchet Effect

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Author Info
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)

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

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Length: 68 pages
Date of creation: Sep 2009
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Handle: RePEc:hbs:wpaper:10-023

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

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Find related papers by JEL classification:
G01 - Financial Economics - - General - - - Financial Crises
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Mortgages
E17 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - Forecasting and Simulation
E27 - Macroeconomics and Monetary Economics - - Macroeconomics: Consumption, Saving, Production, Employment, and Investment - - - Forecasting and Simulation
E37 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Forecasting and Simulation
E47 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Forecasting and Simulation
R21 - Urban, Rural, and Regional Economics - - Household Analysis - - - Housing Demand
R38 - Urban, Rural, and Regional Economics - - Production Analysis and Firm Location - - - Government Policies; Regulatory Policies

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