Selection, Leverage, and Default in the Mortgage Market

Review of Financial Studies, Forthcoming

72 Pages Posted: 26 Jan 2019 Last revised: 1 Jun 2021

See all articles by Arpit Gupta

Arpit Gupta

NYU Stern School of Business

Christopher Hansman

Imperial College Business School

Date Written: April 16, 2021

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.

Keywords: default, adverse selection, moral hazard, mortgage

JEL Classification: D14, G21, D82

Suggested Citation

Gupta, Arpit and Hansman, Christopher, Selection, Leverage, and Default in the Mortgage Market (April 16, 2021). Review of Financial Studies, Forthcoming , Available at SSRN: https://ssrn.com/abstract=3315896 or http://dx.doi.org/10.2139/ssrn.3315896

Arpit Gupta

NYU Stern School of Business ( email )

Suite 9-160
New York, NY
United States

HOME PAGE: http://arpitgupta.info

Christopher Hansman (Contact Author)

Imperial College Business School ( email )

South Kensington Campus
Exhibition Road
London SW7 2AZ, SW7 2AZ
United Kingdom

HOME PAGE: http://chrishansman.com/

Do you have negative results from your research you’d like to share?

Paper statistics

Downloads
262
Abstract Views
1,943
Rank
212,316
PlumX Metrics