Selection, Leverage, and Default in the Mortgage Market

Arpit Gupta and Christopher Hansman

The Review of Financial Studies, 2022, vol. 35, issue 2, 720-770

Abstract: We ask whether the correlation between mortgage leverage and default is due to moral hazard (the causal effect of leverage) or adverse selection (ex ante risky borrowers choosing larger loans). We separate these information asymmetries using a natural experiment resulting from the contract structure of option adjustable-rate mortgages and unexpected 2008 divergence of indexes that determine rate adjustments. Our point estimates suggest that moral hazard is responsible for 40 of the correlation in our sample, while adverse selection explains 60. We calibrate a simple model to show that leverage regulation must weigh default prevention against distortions due to adverse selection.

JEL-codes: D14 D82 G21 (search for similar items in EconPapers)
Date: 2022
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Citations: View citations in EconPapers (2)

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