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Systemic Risk and the Refinancing Ratchet Effect


Amir Khandani


Massachusetts Institute of Technology (MIT)

Andrew W. Lo


Massachusetts Institute of Technology (MIT) - Sloan School of Management; Massachusetts Institute of Technology (MIT) - Computer Science and Artificial Intelligence Laboratory (CSAIL); National Bureau of Economic Research (NBER)

Robert C. Merton


MIT Sloan School of Management; National Bureau of Economic Research (NBER); Harvard Business School - Finance Unit

September 15, 2009

MIT Sloan Research Paper No. 4750-09
Harvard Business School Finance Working Paper No. 1472892

Abstract:     
The confluence of three trends in the U.S. residential housing market - rising home prices, declining interest rates, and near-frictionless refinancing opportunities - led to vastly increased systemic risk in the financial system. Individually, each of these trends is benign, but when they occur simultaneously, as they did over the past decade, they impose an unintentional synchronization of homeowner leverage. This synchronization, coupled with the indivisibility of residential real estate that prevents homeowners from deleveraging when property values decline and homeowner equity deteriorates, conspire to create a “ratchet” effect in which homeowner leverage is maintained or increased during good times without the ability to decrease leverage during bad times. If refinancing-facilitated homeowner-equity extraction is sufficiently widespread - as it was during the years leading up to the peak of the U.S. residential real-estate market - the inadvertent coordination of leverage during a market rise implies higher correlation of defaults during a market drop. To measure the systemic impact of this ratchet effect, we simulate the U.S. housing market with and without equity extractions, and estimate the losses absorbed by mortgage lenders by valuing the embedded put-option in non-recourse mortgages. Our simulations generate loss estimates of $1.5 trillion from June 2006 to December 2008 under historical market conditions, compared to simulated losses of $280 billion in the absence of equity extractions.

Number of Pages in PDF File: 62

Keywords: Systemic Risk, Financial Crisis, Household Finance, Real Estate, Subprime

JEL Classification: G01, G12, G13, G18, G21, E17, E27, E37, E47, R21, R38

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Date posted: September 15, 2009 ; Last revised: February 5, 2012

Suggested Citation

Khandani, Amir and Lo, Andrew W. and Merton, Robert C., Systemic Risk and the Refinancing Ratchet Effect (September 15, 2009). MIT Sloan Research Paper No. 4750-09; Harvard Business School Finance Working Paper No. 1472892. Available at SSRN: http://ssrn.com/abstract=1472892 or http://dx.doi.org/10.2139/ssrn.1472892

Contact Information

Amir E. Khandani
Massachusetts Institute of Technology (MIT) ( email )
77 Massachusetts Avenue
50 Memorial Drive
Cambridge, MA 02139-4307
United States
Andrew W. Lo (Contact Author)
Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )
100 Main Street
E62-618
Cambridge, MA 02142
United States
617-253-0920 (Phone)
781 891-9783 (Fax)
HOME PAGE: http://web.mit.edu/alo/www
Massachusetts Institute of Technology (MIT) - Computer Science and Artificial Intelligence Laboratory (CSAIL)
Stata Center
Cambridge, MA 02142
United States
National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
Robert C. Merton
MIT Sloan School of Management ( email )
77 Massachusetts Avenue
E62-634
Cambridge, MA 02139-4307
United States
617 715 4866 (Phone)
National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
Harvard Business School - Finance Unit ( email )
Boston, MA 02163
United States
617-495-6678 (Phone)
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