Systemic risk and the refinancing ratchet effect

The combination of rising home prices, declining interest rates, and near-frictionless refinancing opportunities can create unintentional synchronization of homeowner leverage, leading to a “ratchet” effect on leverage because homes are indivisible and owner-occupants cannot raise equity to reduce l...

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Bibliographic Details
Published in:Journal of financial economics 2013-04, Vol.108 (1), p.29-45
Main Authors: Khandani, Amir E., Lo, Andrew W., Merton, Robert C.
Format: Article
Language:English
Subjects:
Financial crisis
Financial risks
Financial systems
Household finance
Housing market
Housing prices
Interest rates
Leverage
Losses
Real estate
Refinancing
Risk assessment
Risk management
Studies
Subprime mortgage
Systemic risk
U.S.A
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Summary:The combination of rising home prices, declining interest rates, and near-frictionless refinancing opportunities can create unintentional synchronization of homeowner leverage, leading to a “ratchet” effect on leverage because homes are indivisible and owner-occupants cannot raise equity to reduce leverage when home prices fall. Our simulation of the U.S. housing market yields potential losses of $1.7 trillion from June 2006 to December 2008 with cash-out refinancing vs. only $330 billion in the absence of cash-out refinancing. The refinancing ratchet effect is a new type of systemic risk in the financial system and does not rely on any dysfunctional behaviors.
ISSN:0304-405X
1879-2774
DOI:10.1016/j.jfineco.2012.10.007