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Systemic risk and the refinancing ratchet effect

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  • Khandani, Amir E.
  • Lo, Andrew W.
  • Merton, Robert C.

Abstract

The combination of rising home prices, declining interest rates, and near-frictionless refinancing opportunities can create unintentional synchronization of homeowner leverage, leading to a “ratchet” effect on leverage because homes are indivisible and owner-occupants cannot raise equity to reduce leverage when home prices fall. Our simulation of the U.S. housing market yields potential losses of $1.7 trillion from June 2006 to December 2008 with cash-out refinancing vs. only $330 billion in the absence of cash-out refinancing. The refinancing ratchet effect is a new type of systemic risk in the financial system and does not rely on any dysfunctional behaviors.

Suggested Citation

  • Khandani, Amir E. & Lo, Andrew W. & Merton, Robert C., 2013. "Systemic risk and the refinancing ratchet effect," Journal of Financial Economics, Elsevier, vol. 108(1), pages 29-45.
  • Handle: RePEc:eee:jfinec:v:108:y:2013:i:1:p:29-45
    DOI: 10.1016/j.jfineco.2012.10.007
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    More about this item

    Keywords

    Systemic risk; Financial crisis; Household finance; Real estate; Subprime mortgage;
    All these keywords.

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • 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; Micro Finance Institutions; Mortgages
    • E17 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - Forecasting and Simulation: Models and Applications
    • R28 - Urban, Rural, Regional, Real Estate, and Transportation Economics - - Household Analysis - - - Government Policy

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