Systemic risk and the refinancing ratchet effect |
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Authors: | Amir E Khandani Andrew W Lo Robert C Merton |
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Institution: | 1. Morgan Stanley, New York, United States;2. MIT Sloan School of Management, 100 Main Street, E62-618, Cambridge, MA 02142, United States;3. Laboratory for Financial Engineering, MIT Sloan School of Management, United States;4. AlphaSimplex Group, LLC, United States |
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Abstract: | 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. |
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Keywords: | Systemic risk Financial crisis Household finance Real estate Subprime mortgage |
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