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Contagious Mortgage Default

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  • Børsum, Øystein

    (Dept. of Economics, University of Oslo)

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    Abstract

    This paper analyses the default option typical to American mortgages. House-holds borrow to buy durable housing, but future house prices are uncertain, and households find it advantageous to default on their debt if house prices fall suffi- ciently. A key assumption of the model is that households are relegated to the rental market upon default, and that there is a small pecuniary inefficiency (“iceberg cost”) in renting. This leads defaulters to substitute consumption of other goods for housing; that is, the demand for housing falls upon default. Consequently, when some households default, aggregate demand for housing is reduced, hence house prices fall more, possibly inciting other households to default. This complementarity is a source of multiple equilibria, and a price externality. Using a specific case for which an analytical solution can be derived, I show that contagion is possible: it may be that the default of a minority (interpretable as sub-prime borrowers) spreads to a majority (interpretable as prime borrowers).

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    File URL: http://www.sv.uio.no/econ/english/research/memorandum/pdf-files/2010/Memo-10-2010.pdf
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    Bibliographic Info

    Paper provided by Oslo University, Department of Economics in its series Memorandum with number 10/2010.

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    Length: 36 pages
    Date of creation: 29 Jun 2010
    Date of revision:
    Handle: RePEc:hhs:osloec:2010_010

    Contact details of provider:
    Postal: Department of Economics, University of Oslo, P.O Box 1095 Blindern, N-0317 Oslo, Norway
    Phone: 22 85 51 27
    Fax: 22 85 50 35
    Email:
    Web page: http://www.oekonomi.uio.no/indexe.html
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    Related research

    Keywords: Housing demand; Mortgage market; Default risk; Multiple equilibria Contagion;

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    References

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    1. Manuel Adelino & Kristopher Gerardi & Paul S. Willen, 2009. "Why Don't Lenders Renegotiate More Home Mortgages? Redefaults, Self-Cures and Securitization," NBER Working Papers 15159, National Bureau of Economic Research, Inc.
    2. Christopher L. Foote & Kristopher Gerardi & Paul S. Willen, 2008. "Negative equity and foreclosure: theory and evidence," Public Policy Discussion Paper 08-3, Federal Reserve Bank of Boston.
    3. Peck, James & Shell, Karl, 2001. "Equilibrium Bank Runs," Working Papers 01-10r, Cornell University, Center for Analytic Economics.
    4. Yongheng Deng & John M. Quigley & Robert Van Order, 2000. "Mortgage Terminations, Heterogeneity and the Exercise of Mortgage Options," Econometrica, Econometric Society, vol. 68(2), pages 275-308, March.
    5. Karsten Jeske & Dirk Krueger & Kurt Mitman, 2011. "Housing and the Macroeconomy: The Role of Bailout Guarantees for Government Sponsored Enterprises," NBER Working Papers 17537, National Bureau of Economic Research, Inc.
    6. Satyajit Chatterjee & Burcu Eyigungor, 2009. "Foreclosures and house price dynamics: a quantitative analysis of the mortgage crisis and the foreclosure prevention policy," Working Papers 09-22, Federal Reserve Bank of Philadelphia.
    7. Gervais, Martin, 2002. "Housing taxation and capital accumulation," Journal of Monetary Economics, Elsevier, vol. 49(7), pages 1461-1489, October.
    8. Morris A. Davis & Francois Ortalo-Magne, 2011. "Household Expenditures, Wages, Rents," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 14(2), pages 248-261, April.
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