The Inevitability of Marketwide Underpricing of Mortgage Default Risk |
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Authors: | Andrey Pavlov Susan M Wachter |
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Institution: | Simon Fraser University, Burnaby, British Columbia V5A 1S6, Canada or .;The Wharton School, University of Pennsylvania, Philadelphia, PA 19104-6330 or . |
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Abstract: | 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. |
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