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Working Papers

Real Estate Crashes and Bank Lending

Working paper #451
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% in real estate prices, countries that experienced the symptoms of underpricing suffered a far greater drop in real estate values of 80% or more.

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