Selection, Leverage, and Default in the Mortgage Market

65 Pages Posted: 26 Jan 2019

See all articles by Arpit Gupta

Arpit Gupta

NYU Stern School of Business

Christopher Hansman

Imperial College Business School

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

Gupta, Arpit and Hansman, Christopher, Selection, Leverage, and Default in the Mortgage Market (January 14, 2019). Available at SSRN: or

Arpit Gupta

NYU Stern School of Business ( email )

Suite 9-160
New York, NY
United States


Christopher Hansman (Contact Author)

Imperial College Business School ( email )

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


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