Date of this Version
Real Estate Economics
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.
This is the peer reviewed version of the following article: Pavlov, A. and Wachter, S. M. (2006), The Inevitability of Marketwide Underpricing of Mortgage Default Risk. Real Estate Economics, 34: 479–496. doi:10.1111/j.1540-6229.2006.00175.x , which has been published in final form at http://onlinelibrary.wiley.com/doi/10.1111/j.1540-6229.2006.00175.x/abstract. This article may be used for non-commercial purposes in accordance with Wiley Terms and Conditions for Self-Archiving http://olabout.wiley.com/WileyCDA/Section/id-820227.html#terms.
Pavlov, A., & Wachter, S. M. (2006). The Inevitability of Marketwide Underpricing of Mortgage Default Risk. Real Estate Economics, 34 (4), 479-496. http://dx.doi.org/10.1111/j.1540-6229.2006.00175.x
Date Posted: 27 November 2017