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The Inevitability of Marketwide Underpricing of Mortgage Default Risk
Author(s) -
Pavlov Andrey,
Wachter Susan M.
Publication year - 2006
Publication title -
real estate economics
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.064
H-Index - 61
eISSN - 1540-6229
pISSN - 1080-8620
DOI - 10.1111/j.1540-6229.2006.00175.x
Subject(s) - shareholder , monetary economics , economics , incentive , crash , asset (computer security) , default risk , exploit , financial economics , business , actuarial science , finance , credit risk , microeconomics , corporate governance , computer security , computer science , programming language
Lenders are frequently accused of mispricing the put option embedded in nonrecourse lending. Prior research shows one lender's incentives to underprice. Here, we identify the conditions for a marketwide underpricing equilibrium. We demonstrate that, in a market with many players, given sufficient time, a race to the bottom and marketwide mispricing are inevitable. Underpricing occurs because bank managers and shareholders exploit mispriced deposit insurance. We show that the probability of the underpricing equilibrium increases with time since the previous market crash and that the more volatile the underlying asset market, the more likely it is subject to underpricing.