Stochastic House Appreciation and Optimal Mortgage Lending
Columbia Business School - Finance and Economics
Haas School of Business, UC Berkeley
March 25, 2008
AFA 2009 San Francisco Meetings Paper
We characterize the optimal mortgage contract in a continuous time setting with stochastic growth in house price and income, costly foreclosure, and a risky borrower who requires incentives to repay his debt. We show that many features of subprime loans can be consistent with properties of the optimal contract and that, when house prices decline, mortgage modification can create value for borrowers and lenders. Our model provides a number of empirical predictions that relate the features of mortgage contracts originated in a housing boom and the extent of their modification in a slump to location and borrowers' characteristics.
Number of Pages in PDF File: 59
Keywords: subprime mortgages, house appreciation, optimal contract, mortgage modifcation
JEL Classification: G21, G28, D14
Date posted: March 25, 2008 ; Last revised: August 20, 2011
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