Mortgage Contracts and Household Risk Management

Richard Green (), Amy Cutts () and Buchi Ramagopal
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Buchi Ramagopal: Citigroup

Working Papers from School of Business, The George Washington University

Abstract: The real estate finance literature provides rich insights into circumstances that expose mortgage borrowers to risk. However, there is no characterization of how mortgage contracts might play a role in helping households manage their portfolio risks. This paper provides a framework for evaluating the implications of mortgage choice for the risk management of households. Starting with an empirical characterization of the assets and liabilities of a representative household, we build a framework to determine how they manage the duration and convexity of household equity at various stages of the life cycle. Our risk management framework takes into account the relationship between the most important asset of the household – their human capital – and their most important liability – the mortgage. The embedded call and put options of the mortgage contract are well known. Households also have implicit call and put options on the asset side of the balance sheet in the form of their human capital. The puts and calls of the mortgages and human capital to some extent help households reduce the net duration and convexity of their equity. We find strong evidence that human capital does matter in the mortgage choice, at least with respect to the variability of employment by sector, whether the borrower is self-employed, or a young college graduate. We also find that total indebtedness and leverage play an important role in mortgage choice.

Date: 2006-01
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