Selection, Leverage, and Default in the Mortgage Market
65 Pages Posted: 26 Jan 2019
Date Written: January 14, 2019
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 (i) the unique contract structure of Option Adjustable-Rate Mortgages and (ii) the unexpected 2008 divergence of the indices that determine interest rate adjustments. Moral hazard is responsible for 60-70% of the correlation, while adverse selection explains 30-40%. We construct and calibrate a simple model to show that optimal regulation of leverage must weigh default-prevention against market distortions due to adverse selection.
Keywords: default, adverse selection, moral hazard, mortgage
JEL Classification: D14, G21, D82
Suggested Citation: Suggested Citation