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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.

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

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

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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

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