"Stochastic House Appreciation and Optimal Mortgage Lending"
©
Review of Financial Studies,
May
2011
Volume: 24
|
Issue: 5
|
Pages: 1407-1446
Publication type: Journal article
Research Archive Topic: Business Economics and Public Policy, Capital Markets and Investments, Corporate Finance, Real Estate
Abstract
We characterize the optimal mortgage contract in a continuous time setting with stochastic growth in house price and income, costly foreclosure, and a risky borrower who requires incentives to repay his debt. We show that many features of subprime loans can be consistent with properties of the optimal contract and that, when house prices decline, mortgage modification can create value for borrowers and lenders. Our model provides a number of empirical predictions that relate the features of mortgage contracts originated in a housing boom and the extent of their modification in a slump to location and borrowers' characteristics.
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