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Mortgage Default Option Mispricing and Procyclicality

Working paper #745
Andrew Davidson, Alex Levin and Susan M. Wachter

This paper examines the role of mortgage supply characteristics in both affordability and financial risk outcomes, in the wake of the mortgage crisis. A hallmark of the crisis was a shift in mortgage lending products, such as interest only, negative amortization or subprime mortgages. What impact did this shift have on consumers, investors and the overall financial system? In an effort to better understand the impact of various products on affordability as well as financial risk outcomes, we address the performance of these products and their interaction with the financial sector in the production of systemic risk. While ex post the performance of these mortgages was disastrous and neither expected nor priced, we also show that ex ante credit risk was mispriced. While it may seem obvious that such instruments allow more borrowing than otherwise would occur in previously affordability and credit score-constrained markets, this may not be the case. In fact we show, that, although the credit box was expanded by these products, this expansion occurred without an increase in homeownership.

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