An Equilibrium Model of Housing and Mortgage Markets with State-Contingent Lending Contracts

Abstract

We develop a tractable general equilibrium framework of housing and mortgage markets with aggregate and idiosyncratic risks, costly defaults, empirically relevant informational asymmetries, and competition in mortgage design. We characterize equilibrium mortgage contracts when indexation to aggregate states of the economy is possible. If borrowers' individual homeownership values are known, the equilibrium state-contingent mortgage payments positively depend on aggregate wages and house prices. When lenders cannot observe these values, the equilibrium contract only depends on house prices and takes the form of a home equity insurance mortgage (HEIM). Interestingly, while beneficial for most borrowers, HEIMs may decrease homeownership rate and welfare of marginal homebuyers. In some cases, unrestricted competition in mortgage design may lead to non-existence of equilibrium.

Keywords: State-contingent lending contracts, mortgage design, home equity insurance, asymmetric information, housing market, general equilibrium

JEL Classification: G21, G28, G01, D1, D5, E3