Selection, leverage, and default in the mortgage market
File(s)
Published version
Author(s)
Gupta, Arpit
Hansman, Christopher
Type
Journal Article
Abstract
We ask whether the correlation between mortgage leverage and default is due to moral hazard (the causal
effect of leverage) or adverse selection (ex-ante risky borrowers choosing larger loans). We separate these
information asymmetries using a natural experiment resulting from the contract structure of Option Adjustable Rate Mortgages and unexpected 2008 divergence of indexes that determine rate adjustments. Our point
estimates suggest that moral hazard is responsible for 40% of the correlation in our sample while adverse
selection explains 60%. We calibrate a simple model to show that leverage regulation must weigh default prevention against distortions due to adverse selection
effect of leverage) or adverse selection (ex-ante risky borrowers choosing larger loans). We separate these
information asymmetries using a natural experiment resulting from the contract structure of Option Adjustable Rate Mortgages and unexpected 2008 divergence of indexes that determine rate adjustments. Our point
estimates suggest that moral hazard is responsible for 40% of the correlation in our sample while adverse
selection explains 60%. We calibrate a simple model to show that leverage regulation must weigh default prevention against distortions due to adverse selection
Date Issued
2022-02-01
Date Acceptance
2021-02-03
Citation
The Review of Financial Studies, 2022, 35 (2), pp.720-770
ISSN
0893-9454
Publisher
Oxford University Press (OUP)
Start Page
720
End Page
770
Journal / Book Title
The Review of Financial Studies
Volume
35
Issue
2
Copyright Statement
© The Author(s) 2021. Published by Oxford University Press.
This is an Open Access article distributed under the terms of the Creative Commons Attribution License
(http://creativecommons.org/licenses/by/4.0/), which permits unrestricted reuse, distribution, and reproduction
in any medium, provided the original work is properly cited.
This is an Open Access article distributed under the terms of the Creative Commons Attribution License
(http://creativecommons.org/licenses/by/4.0/), which permits unrestricted reuse, distribution, and reproduction
in any medium, provided the original work is properly cited.
License URL
Subjects
default
adverse selection
moral hazard
mortgage
Publication Status
Published
Date Publish Online
2021-04-27