IDEAS home Printed from https://ideas.repec.org/
MyIDEAS: Log in (now much improved!) to save this article

Systemic risk and the refinancing ratchet effect

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

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.

If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.

File URL: http://www.sciencedirect.com/science/article/pii/S0304405X1200219X
Download Restriction: Full text for ScienceDirect subscribers only

As the access to this document is restricted, you may want to look for a different version under "Related research" (further below) or search for a different version of it.

Article provided by Elsevier in its journal Journal of Financial Economics.

Volume (Year): 108 (2013)
Issue (Month): 1 ()
Pages: 29-45

as
in new window

Handle: RePEc:eee:jfinec:v:108:y:2013:i:1:p:29-45
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/505576

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:

as in new window
  1. Carmen M. Reinhart & Kenneth S. Rogoff, 2009. "Is the 2007 U.S. Sub-Prime Financial Crisis So Different? An International Historical Comparison," Panoeconomicus, Savez ekonomista Vojvodine, Novi Sad, Serbia, vol. 56(3), pages 291-299, September.
  2. Kau, James B, et al, 1995. "The Valuation at Origination of Fixed-Rate Mortgages with Default and Prepayment," The Journal of Real Estate Finance and Economics, Springer, vol. 11(1), pages 5-36, July.
  3. Kau James B. & Keenan Donald C. & Kim Taewon, 1994. "Default Probabilities for Mortgages," Journal of Urban Economics, Elsevier, vol. 35(3), pages 278-296, May.
  4. Paul S. Willen & Adam Hale Shapiro & Kristopher Gerardi, 2008. "Subprime Outcomes: Risky Mortgages, Homeownership Experiences, and Foreclosures," 2008 Meeting Papers 345, Society for Economic Dynamics.
  5. Sumit Agarwal & John C. Driscoll & David I. Laibson, 2013. "Optimal Mortgage Refinancing: A Closed‐Form Solution," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 45(4), pages 591-622, 06.
  6. Michelle A. Danis & Anthony Pennington-Cross, 2005. "A dynamic look at subprime loan performance," Working Papers 2005-029, Federal Reserve Bank of St. Louis.
  7. Bekaert, Geert & Wu, Guojun, 2000. "Asymmetric Volatility and Risk in Equity Markets," Review of Financial Studies, Society for Financial Studies, vol. 13(1), pages 1-42.
  8. Gary B. Gorton, 2008. "The Subprime Panic," NBER Working Papers 14398, National Bureau of Economic Research, Inc.
  9. Giovanni Dell'Ariccia & Luc Laeven & Deniz Igan, 2008. "Credit Booms and Lending Standards; Evidence From the Subprime Mortgage Market," IMF Working Papers 08/106, International Monetary Fund.
  10. Jonathan McCarthy & Richard Peach, 2004. "Are home prices the next "bubble"?," Economic Policy Review, Federal Reserve Bank of New York, issue Dec, pages 1-17.
  11. Yuliya Demyanyk & Otto Van Hemert, 2008. "Understanding the subprime mortgage crisis," Proceedings 1092, Federal Reserve Bank of Chicago.
  12. Raghuram G. Rajan, 2006. "Has Finance Made the World Riskier?," European Financial Management, European Financial Management Association, vol. 12(4), pages 499-533.
  13. Yongheng Deng & John M. Quigley, 2003. "Woodhead Behavior and the Pricing of Residential Mortgages," Working Paper 8616, USC Lusk Center for Real Estate.
  14. Joshua Gallin, 2006. "The Long-Run Relationship between House Prices and Income: Evidence from Local Housing Markets," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 34(3), pages 417-438, 09.
  15. Foote, Christopher L. & Gerardi, Kristopher & Willen, Paul S., 2008. "Negative equity and foreclosure: Theory and evidence," Journal of Urban Economics, Elsevier, vol. 64(2), pages 234-245, September.
  16. 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.
  17. Kerry D. Vandell, 1993. "Handing Over the Keys: A Perspective on Mortgage Default Research," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 21(3), pages 211-246.
  18. George M. Constantinides, 1976. "Stochastic Cash Management with Fixed and Proportional Transaction Costs," Management Science, INFORMS, vol. 22(12), pages 1320-1331, August.
  19. Gary Gorton & Andrew Metrick, 2010. "Securitized Banking and the Run on Repo," NBER Chapters, in: Market Institutions and Financial Market Risk National Bureau of Economic Research, Inc.
  20. Geetesh Bhardwaj & Rajdeep Sengupta, 2008. "Did prepayments sustain the subprime market?," Working Papers 2008-039, Federal Reserve Bank of St. Louis.
  21. Carmen M. Reinhart & Kenneth S. Rogoff, 2008. "This Time is Different: A Panoramic View of Eight Centuries of Financial Crises," NBER Working Papers 13882, National Bureau of Economic Research, Inc.
  22. Kau, James B, et al, 1992. "A Generalized Valuation Model for Fixed-Rate Residential Mortgages," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 24(3), pages 279-99, August.
  23. Souphala Chomsisengphet & Anthony Pennington-Cross, 2006. "Subprime refinancing: equity extraction and mortgage termination," Working Papers 2006-023, Federal Reserve Bank of St. Louis.
  24. Kristopher Gerardi & Andreas Lehnert & Shane M. Sherlund & Paul Willen, 2008. "Making Sense of the Subprime Crisis," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 39(2 (Fall)), pages 69-159.
  25. Patrick Bajari & Chenghuan Sean Chu & Minjung Park, 2008. "An Empirical Model of Subprime Mortgage Default From 2000 to 2007," NBER Working Papers 14625, National Bureau of Economic Research, Inc.
  26. Hurst, Erik & Stafford, Frank, 2004. "Home Is Where the Equity Is: Mortgage Refinancing and Household Consumption," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 36(6), pages 985-1014, December.
  27. Andra C. Ghent & Marianna Kudlyak, 2010. "Recourse and residential mortgage default: theory and evidence from U.S. states," Working Paper 09-10, Federal Reserve Bank of Richmond.
  28. Constantinides, George M, 1986. "Capital Market Equilibrium with Transaction Costs," Journal of Political Economy, University of Chicago Press, vol. 94(4), pages 842-62, August.
  29. Markus K. Brunnermeier, 2009. "Deciphering the Liquidity and Credit Crunch 2007-2008," Journal of Economic Perspectives, American Economic Association, vol. 23(1), pages 77-100, Winter.
  30. Andrew W. Lo & Harry Mamaysky & Jiang Wang, 2004. "Asset Prices and Trading Volume under Fixed Transactions Costs," Journal of Political Economy, University of Chicago Press, vol. 112(5), pages 1054-1090, October.
  31. M. B. Haugh & A. W. Lo, 2001. "Asset allocation and derivatives," Quantitative Finance, Taylor & Francis Journals, vol. 1(1), pages 45-72.
  32. Joshua H. Gallin, 2004. "The long-run relationship between house prices and rents," Finance and Economics Discussion Series 2004-50, Board of Governors of the Federal Reserve System (U.S.).
  33. Luigi Guiso & Paola Sapienza & Luigi Zingales, 2009. "Moral and Social Constraints to Strategic Default on Mortgages," Economics Working Papers ECO2009/27, European University Institute.
  34. Paul Bennett & Richard Peach & Stavros Peristiani, 1997. "Structural change in the mortgage market and the propensity to refinance," Research Paper 9736, Federal Reserve Bank of New York.
  35. Charles P. Himmelberg & Christopher J. Mayer & Todd Sinai, 2005. "Assessing high house prices: bubbles, fundamentals, and misperceptions," Staff Reports 218, Federal Reserve Bank of New York.
  36. Tomasz Piskorski & Alexei Tchistyi, 2010. "Optimal Mortgage Design," Review of Financial Studies, Society for Financial Studies, vol. 23(8), pages 3098-3140, August.
  37. Coleman IV, Major & LaCour-Little, Michael & Vandell, Kerry D., 2008. "Subprime lending and the housing bubble: Tail wags dog?," Journal of Housing Economics, Elsevier, vol. 17(4), pages 272-290, December.
  38. Atif Mian & Amir Sufi, 2011. "House Prices, Home Equity-Based Borrowing, and the US Household Leverage Crisis," American Economic Review, American Economic Association, vol. 101(5), pages 2132-56, August.
  39. Gary Gorton, 2008. "The Panic of 2007," Yale School of Management Working Papers amz2372, Yale School of Management.
  40. Andrew W. Lo & Jiang Wang, 1994. "Implementing Option Pricing Models When Asset Returns Are Predictable," NBER Working Papers 4720, National Bureau of Economic Research, Inc.
  41. Dale F. Gray & Robert C. Merton & Zvi Bodie, 2007. "New Framework for Measuring and Managing Macrofinancial Risk and Financial Stability," NBER Working Papers 13607, National Bureau of Economic Research, Inc.
  42. Alan Greenspan & James E. Kennedy, 2007. "Sources and uses of equity extracted from homes," Finance and Economics Discussion Series 2007-20, Board of Governors of the Federal Reserve System (U.S.).
  43. Sanford J. Grossman & Guy Laroque, 1987. "Asset Pricing and Optimal Portfolio Choice in the Presence of Illiquid Durable Consumption Goods," NBER Working Papers 2369, National Bureau of Economic Research, Inc.
  44. Shiller Robert J., 2006. "Long-Term Perspectives on the Current Boom in Home Prices," The Economists' Voice, De Gruyter, vol. 3(4), pages 1-11, March.
  45. Alan Greenspan & James E. Kennedy, 2005. "Estimates of home mortgage originations, repayments, and debt on one-to-four-family residences," Finance and Economics Discussion Series 2005-41, Board of Governors of the Federal Reserve System (U.S.).
  46. Chris Downing & Richard Stanton & Nancy Wallace, 2005. "An Empirical Test of a Two-Factor Mortgage Valuation Model: How Much Do House Prices Matter?," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 33(4), pages 681-710, December.
  47. Christopher J. Mayer & Karen Pence, 2008. "Subprime Mortgages: What, Where, and to Whom?," NBER Working Papers 14083, National Bureau of Economic Research, Inc.
  48. Gorton, Gary B., 2008. "The panic of 2007," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 131-262.
  49. Schwartz, Eduardo S & Torous, Walter N, 1989. " Prepayment and the Valuation of Mortgage-Backed Securities," Journal of Finance, American Finance Association, vol. 44(2), pages 375-92, June.
  50. Atif Mian & Amir Sufi, 2008. "The Consequences of Mortgage Credit Expansion: Evidence from the 2007 Mortgage Default Crisis," NBER Working Papers 13936, National Bureau of Economic Research, Inc.
  51. Stanton, Richard, 1995. "Rational Prepayment and the Valuation Mortgage-Backed Securities," Review of Financial Studies, Society for Financial Studies, vol. 8(3), pages 677-708.
  52. Robert C. Merton & Zvi Bodie, 1992. "On the Management of Financial Guarantees," Financial Management, Financial Management Association, vol. 21(4), Winter.
  53. Merton, Robert C., 1976. "Option pricing when underlying stock returns are discontinuous," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 125-144.
  54. Mark Doms & Frederick T. Furlong & John Krainer, 2007. "Subprime mortgage delinquency rates," Working Paper Series 2007-33, Federal Reserve Bank of San Francisco.
  55. Christopher J. Mayer & Karen M. Pence, 2008. "Subprime mortgages: what, where, and to whom?," Finance and Economics Discussion Series 2008-29, Board of Governors of the Federal Reserve System (U.S.).
  56. Benjamin J. Keys & Tanmoy Mukherjee & Amit Seru & Vikrant Vig, 2010. "Did Securitization Lead to Lax Screening? Evidence from Subprime Loans," The Quarterly Journal of Economics, Oxford University Press, vol. 125(1), pages 307-362.
  57. Merton, Robert C., 1977. "An analytic derivation of the cost of deposit insurance and loan guarantees An application of modern option pricing theory," Journal of Banking & Finance, Elsevier, vol. 1(1), pages 3-11, June.
  58. Hubbard R. Glenn & Mayer Christopher J, 2009. "The Mortgage Market Meltdown and House Prices," The B.E. Journal of Economic Analysis & Policy, De Gruyter, vol. 9(3), pages 1-47, March.
  59. Stavros Peristiani & Paul Bennett & Gordon Monsen & Richard Peach & Jonathan Raiff, 1997. "Credit, equity, and mortgage refinancings," Economic Policy Review, Federal Reserve Bank of New York, issue Jul, pages 83-99.
  60. Andrew W. Lo, 2012. "Reading about the Financial Crisis: A Twenty-One-Book Review," Journal of Economic Literature, American Economic Association, vol. 50(1), pages 151-78, March.
  61. Geetesh Bhardwaj & Rajdeep Sengupta, 2008. "Where's the smoking gun? a study of underwriting standards for US subprime mortgages," Working Papers 2008-036, Federal Reserve Bank of St. Louis.
  62. Dale F. Gray & Robert C. Merton & Zvi Bodie, 2006. "A New Framework for Analyzing and Managing Macrofinancial Risks of an Economy," NBER Working Papers 12637, National Bureau of Economic Research, Inc.
Full references (including those not matched with items on IDEAS)

This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

When requesting a correction, please mention this item's handle: RePEc:eee:jfinec:v:108:y:2013:i:1:p:29-45. See general information about how to correct material in RePEc.

For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Zhang, Lei)

If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

If references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

Please note that corrections may take a couple of weeks to filter through the various RePEc services.

This information is provided to you by IDEAS at the Research Division of the Federal Reserve Bank of St. Louis using RePEc data.