Mastering the metropolis through research and thought leadership.
Working Papers

Real Estate Crashes and Bank Lending

Working paper #506
Andrey D. Pavlov and Susan M. Wachter

This paper analyzes the role that non-recourse bank lending plays in generating boom and bust cycles in real estate. The ability to default on a loan represents a put option written by the lender and owned by the borrower. Rational economic behavior typically dictates that lenders charge the borrower for the imbedded put option through higher interest rates, origination fees, or mortgage insurance. In this paper, we discuss the conditions that lead lenders to rationally underprice the put option imbedded in non-recourse lending and analyze the impact of put option underpricing on asset prices. We find an underpricing equilibrium in which all lenders rationally choose to underprice the put option. This underpricing results in inflated asset prices, compression in the spread between lending and deposit rates, lending booms and real estate crashes. We apply this model to the real estate bubble in five Asian countries during the 1990s. Macroeconomic instability and higher interest rates both worked to induce price declines. Nonetheless, while countries in which underpricing was curtailed through government policy or institutional improvements experienced a decline of 30 to 40 percent in real estate prices, countries that experienced the symptoms of underpricing suffered a far greater drop in real estate values of 80 percent or more.

Download full paper · 1MB PDF

In This Section
Explore Topics

1010 Affordable Housing Amazon Amenitization Architecture Artificial Intelligence Asia Australia automation Autonomous Vehicles bonds Borrowing Constraints Brexit California Canada Capital Business China Co-Working Environment coastal markets cold storage Colombia Commercial Brokerage Commercial Real Estate commissions Congestion consumer bias covid-19 CRE credit card market Credit Default Swaps Credit Insurance Credit Risk Transfers Culture Data Analytics data centers Data Collection Technology Debt Market Demand Demographics Density Development Discrete Choice disruption Diversity drones e-Commerce Economic Corridors economic policy economics education election studies Equity Funds Equity Market Ethnic Factors Europe Fannie Mae financial asset management Foreclosures Foreign Policy France Freddie Mac general equilibrium Global global economy Global Financial Crisis Globalization great depression Great Recession healthy buildings Hedonic hospitality Housing & Residential housing boom Housing Disease housing prices Housing Supply Identity Income Inequality India inflation Inter-generational mobility interest rates Investing jobs labor market Lagging Regions land use regulation Language life sciences Macroeconomics malls Market Pricing megacities Microeconomics Migration Minimum Payments Mixed-Use Mobility moral hazard mortgage insurance mortgage market Mortgage Rates Mortgages Multi-family Nation Building Non-Traditional Mortgages Office Market office sector pension funds Placed Based Policies Political Risk Price Discovery Private Equity Business public health public policy Public Schools real estate brokerage Real Estate Investment Real Estate Investment Trusts Recession Rental Retail Retirement reverse mortgages Risk Adjustment risk management risk-shifting robotics single family housing Slums Sorting South America Spatial Regions spillover effect stimulus package Sub-Prime Mortgages Supply Chains Sustainability Technology telecommunications trade transportation unemployment United States Urban Urbanization Warehouse welfare work from home