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Aggressive Lending and Real Estate Markets

Working paper #566
Andrey D. Pavlov and Susan M. Wachter

This paper establishes a theoretical and empirical link between the use of aggressive mortgage lending instruments and the underlying house price volatility. Within the context of a general equilibrium model with borrowing constraints, we demonstrate that the supply of aggressive lending instruments, such as non-amortizing low-equity mortgages, increases the asset prices in the underlying market because borrowers use these instruments to further leverage their current income. Thus, the aggressive lending instruments effectively relax the borrowing constraint faced by prospective homeowners. Furthermore, in our model lenders rationally re-price all mortgage instruments following a negative demand shock. We show that the relative use of aggressive lending instruments declines following a negative demand shock whether this re-pricing is anticipated or not. These two results provide for the important policy implication that the availability of aggressive mortgage lending instruments magnifies the real estate cycle and the effects of large negative demand shocks. Using both local and national price index data we empirically confirm the predictions of the model. In particular, we find that neighborhoods and cities that experienced a high concentration of aggressive lending instruments at their respective real estate market peaks suffered more severe price declines and a lower supply of aggressive instruments following a negative demand shock. Overall, we find that the fluctuation of supply of aggressive lending instruments increases the volatility of the underlying asset prices over the course of the market cycle.

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