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The Solvency Paradox: How Risk-Based Mortgage Pricing Transforms Credit Rationing into Delayed Default

Author

Listed:
  • Ji, Zihao
  • Zhang, Mengchen
  • Wang, Guan
  • Zhang, Hongru

Abstract

Does replacing hard debt-to-income (DTI) limits with risk-adjusted pricing improve household welfare? We develop a heterogeneous agent life-cycle model incorporating behavioral flow disutility, endogenous credit menus, and regime-switching income risk. Simulating a "Double Trigger" crisis, we uncover a Solvency Paradox: price-based regulation eliminates immediate credit rationing but imposes risk premia that erode liquidity buffers, generating a 53.7% cumulative default rate among marginal borrowers exceeding the counterfactual exclusion rate under quantity limits. Welfare consequences are starkly regressive: the "marginal middle class" suffers 6.7% consumption-equivalent losses while wealthy households gain 2.1%. Our policy comparison reveals a state-contingent hierarchy: forbearance efficiently resolves transitory liquidity shocks, while principal reduction is necessary for persistent solvency crises. State-contingent contracts (Shared Responsibility Mortgages) achieve intermediate efficacy with superior dynamic stability. Marginal credit expansions are dominated across all simulated shock scenarios. Optimal macro-prudential design requires severing the link between income shocks and debt service burdens.

Suggested Citation

  • Ji, Zihao & Zhang, Mengchen & Wang, Guan & Zhang, Hongru, 2026. "The Solvency Paradox: How Risk-Based Mortgage Pricing Transforms Credit Rationing into Delayed Default," MPRA Paper 128531, University Library of Munich, Germany.
    • Handle: RePEc:pra:mprapa:128531
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    References listed on IDEAS

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    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • R21 - Urban, Rural, Regional, Real Estate, and Transportation Economics - - Household Analysis - - - Housing Demand

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