Asymmetric Information and the Link Between Leverage and Mortgage Default

Borrowers with large mortgages relative to their home values are more likely to default. This paper asks whether this correlation is due to moral hazard—larger balances causing borrowers to default— or adverse selection—ex-ante risky borrowers choosing larger loans. To separate these information asymmetries, I exploit a natural experiment resulting from (i) the unique contract structure of Option Adjustable Rate Mortgages and (ii) the unexpected divergence, during the 2008 crisis, of two financial indices used to determine interest rate adjustments for these loans. I find that moral hazard is responsible for 60-70 percent of the baseline correlation between leverage and default, but adverse selection explains the remaining 30-40 percent. I construct and calibrate a simple model of mortgage choice and default with asymmetric information to highlight the policy tradeoff informed by my estimates. I show that optimal regulation of mortgage leverage must weigh losses from defaults against under-provision of credit due to adverse selection. ∗Columbia University. Email: [email protected]. I am indebted to Pierre-André Chiappori, Jonas Hjort, Wojciech Kopczuk, and Bernard Salanié for their advice and guidance. I would additionally like to thank Eduardo Dávila, François Gerard, Arpit Gupta, Henrik Kleven, Rocco Macchiavello, Dan O’Flaherty, Tomasz Piskorski, Miikka Rokkanen, Christoph Rothe, Johannes Spinnewijn, Miguel Urquiola, Eric Verhoogen, and members of the microeconomics colloquia at Columbia for their helpful comments and suggestions. This work has been supported by the National Science Foundation (SES-1559460) and by award # 98-16-02 from the Russell Sage Foundation. Any opinions expressed are mine alone and should not be construed as representing the opinions of the National Science Foundation or the Russell Sage Foundation.