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Stochastic House Appreciation and Optimal Mortgage Lending

  • Alexei Tchistyi

    (NYU Stern)

  • Tomasz Piskorski

    (Columbia Business School)

Registered author(s):

    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: https://economicdynamics.org/meetpapers/2008/paper_938.pdf
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    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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    Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA

    Web page: http://www.EconomicDynamics.org/society.htm
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    1. Posey, Lisa L. & Yavas, Abdullah, 2001. "Adjustable and Fixed Rate Mortgages as a Screening Mechanism for Default Risk," Journal of Urban Economics, Elsevier, vol. 49(1), pages 54-79, January.
    2. LeRoy, Stephen F, 1996. "Mortgage Valuation under Optimal Prepayment," Review of Financial Studies, Society for Financial Studies, vol. 9(3), pages 817-44.
    3. Richard Stanton & Nancy Wallace, 1998. "Mortgage Choice: What's the Point?," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 26(2), pages 173-205.
    4. Joao Cocco & John Campbell, 2004. "Household Risk Management and Optimal Mortgage Choice," Econometric Society 2004 North American Winter Meetings 632, Econometric Society.
    5. Christopher Phelan & Robert M. Townsend, 1991. "Computing Multi-Period, Information-Constrained Optima," Review of Economic Studies, Oxford University Press, vol. 58(5), pages 853-881.
    6. Yacine Ait-Sahalia & Jonathan A. Parker & Motohiro Yogo, 2002. "Luxury Goods and the Equity Premium," Working Papers 145, Princeton University, Woodrow Wilson School of Public and International Affairs, Discussion Papers in Economics.
    7. Stephen E. Spear & Sanjay Srivastava, 1987. "On Repeated Moral Hazard with Discounting," Review of Economic Studies, Oxford University Press, vol. 54(4), pages 599-617.
    8. Sumit Agarwal & Calvin T. Ho, 2007. "Comparing the prime and subprime mortgage markets," Chicago Fed Letter, Federal Reserve Bank of Chicago, issue Aug.
    9. Bruno Biais & Thomas Mariotti & Guillaume Plantin & Jean-Charles Rochet, 2007. "Dynamic Security Design: Convergence to Continuous Time and Asset Pricing Implications," Review of Economic Studies, Oxford University Press, vol. 74(2), pages 345-390.
    10. Peter M. DeMarzo & Michael J. Fishman, 2007. "Agency and Optimal Investment Dynamics," Review of Financial Studies, Society for Financial Studies, vol. 20(1), pages 151-188, January.
    11. Dunn, Kenneth B & Spatt, Chester S, 1985. " An Analysis of Mortgage Contracting: Prepayment Penalties and the Due-on-Sale Clause," Journal of Finance, American Finance Association, vol. 40(1), pages 293-308, March.
    12. 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.
    13. Chari, V V & Jagannathan, Ravi, 1989. " Adverse Selection in a Model of Real Estate Lending," Journal of Finance, American Finance Association, vol. 44(2), pages 499-508, June.
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