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Stochastic House Appreciation and Optimal Mortgage Lending

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  • Alexei Tchistyi

    (NYU Stern)

  • Tomasz Piskorski

    (Columbia Business School)

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    Abstract

    Assuming full rationality, we characterize the optimal mortgage contract in a continuous time setting with a risky borrower, costly default, a moral hazard problem between the borrower and the lender, and a stochastic house appreciation. We show that many features of subprime lending observed in practice are consistent with economic e¢ ciency and rationality of both borrowers and lenders. In particular, preferential treatment of subprime borrowers is optimal during the housing boom, while default clustering among subprime borrowers is optimal during the housing slump. We also find that stochastic house appreciation makes it profitable to give loans to subprime borrowers who otherwise would be shut out of the housing market, which generates substantial ex-ante utility gains for these borrowers.

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    File URL: http://www.economicdynamics.org/meetpapers/2008/paper_938.pdf
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    Bibliographic Info

    Paper provided by Society for Economic Dynamics in its series 2008 Meeting Papers with number 938.

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    Date of creation: 2008
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    Handle: RePEc:red:sed008:938

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    1. Yacine A�T-Sahalia & Jonathan A. Parker & Motohiro Yogo, 2004. "Luxury Goods and the Equity Premium," Journal of Finance, American Finance Association, American Finance Association, vol. 59(6), pages 2959-3004, December.
    2. Christopher Phelan & Robert M Townsend, 2010. "Computing Multi-Period, Information Constrained Optima," Levine's Working Paper Archive 117, David K. Levine.
    3. Campbell, John & Cocco, Joao, 2003. "Household Risk Management and Optimal Mortgage Choice," Scholarly Articles 3157876, Harvard University Department of Economics.
    4. Kau, James B, et al, 1992. "A Generalized Valuation Model for Fixed-Rate Residential Mortgages," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 24(3), pages 279-99, August.
    5. Ambrose, Brent W & Buttimer, Richard J, Jr & Capone, Charles A, 1997. "Pricing Mortgage Default and Foreclosure Delay," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 29(3), pages 314-25, August.
    6. Kristopher Gerardi & Harvey S. Rosen & Paul Willen, 2006. "Do households benefit from financial deregulation and innovation?: the case of the mortgage market," Public Policy Discussion Paper, Federal Reserve Bank of Boston 06-6, Federal Reserve Bank of Boston.
    7. Biais, Bruno & Mariotti, Thomas & Plantin, Guillaume & Rochet, Jean-Charles, 2004. "Dynamic Security Design: Convergence to Continuous Time and Asset Pricing Implications," IDEI Working Papers, Institut d'Économie Industrielle (IDEI), Toulouse 312, Institut d'Économie Industrielle (IDEI), Toulouse, revised Sep 2006.
    8. Spear, Stephen E & Srivastava, Sanjay, 1987. "On Repeated Moral Hazard with Discounting," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 54(4), pages 599-617, October.
    9. Chari, V V & Jagannathan, Ravi, 1989. " Adverse Selection in a Model of Real Estate Lending," Journal of Finance, American Finance Association, American Finance Association, vol. 44(2), pages 499-508, June.
    10. Peter M. DeMarzo & Michael J. Fishman, 2007. "Agency and Optimal Investment Dynamics," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 20(1), pages 151-188, January.
    11. LeRoy, Stephen F, 1996. "Mortgage Valuation under Optimal Prepayment," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 9(3), pages 817-44.
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    Cited by:
    1. Piskorski, Tomasz & Seru, Amit & Vig, Vikrant, 2010. "Securitization and distressed loan renegotiation: Evidence from the subprime mortgage crisis," Journal of Financial Economics, Elsevier, Elsevier, vol. 97(3), pages 369-397, September.

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