Stochastic House Appreciation and Optimal Mortgage Lending

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  • 1 January 2008
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      • Published in RePEc
Abstract
Assuming full rationality, we characterize the optimal mortgage contract in a continuous time setting with a risky borrower, costly default, a moral hazard problem between the borrower and the lender, and a stochastic house appreciation. We show that many features of subprime lending observed in practice are consistent with economic e¢ ciency and rationality of both borrowers and lenders. In particular, preferential treatment of subprime borrowers is optimal during the housing boom, while default clustering among subprime borrowers is optimal during the housing slump. We also find that stochastic house appreciation makes it profitable to give loans to subprime borrowers who otherwise would be shut out of the housing market, which generates substantial ex-ante utility gains for these borrowers.
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