The Inevitability of Market-Wide Underpricing of Mortgage Default Risk

34 Pages Posted: 23 Jun 2006

See all articles by Andrey D. Pavlov

Andrey D. Pavlov

Simon Fraser University (SFU) - Finance Area

Susan M. Wachter

University of Pennsylvania - Wharton School, Department of Real Estate ; University of Pennsylvania - Finance Department

Abstract

Lenders are frequently accused of mispricing the put option imbedded in non-recourse lending (Herring and Wachter, 1999 and 2003). Prior research (Pavlov and Wachter, 2004) shows one lender's incentives to underprice. Here we identify the conditions for a market-wide underpricing equilibrium. We demonstrate that in a market with many players, given sufficient time, a race to the bottom and market-wide mispricing are inevitable. Underpricing occurs because bank managers and shareholders exploit mis-priced deposit insurance. We show that the probability of the underpricing equilibrium increases with time since the previous market crash and that the more volatile the underlying asset market, the more likely it is subject to underpricing

Keywords: mortgage underpricing, mortgage default

JEL Classification: G12, G13, G21

Suggested Citation

Pavlov, Andrey D. and Wachter, Susan M., The Inevitability of Market-Wide Underpricing of Mortgage Default Risk. Real Estate Economics, Forthcoming; U of Penn, Inst for Law & Econ Research Paper No. 06-14. Available at SSRN: https://ssrn.com/abstract=910970

Andrey D. Pavlov

Simon Fraser University (SFU) - Finance Area ( email )

Burnaby, British Columbia V5A 1S6
Canada
604 291 5835 (Phone)
604 291 4920 (Fax)

Susan M. Wachter (Contact Author)

University of Pennsylvania - Wharton School, Department of Real Estate ( email )

The Wharton School
3620 Locust Walk
Philadelphia, PA 19104-6330
United States
215-898-6355 (Phone)

HOME PAGE: http://real.wharton.upenn.edu/~wachter/index.html

University of Pennsylvania - Finance Department ( email )

The Wharton School
3620 Locust Walk
Philadelphia, PA 19104
United States

HOME PAGE: http://real.wharton.upenn.edu/~wachter/index.html

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