The US has an optimal mortgage market, Part 2

Back in January, I found a wonderful paper by the New York Fed’s James Vickery which showed that homebuyers are very, very sensitive to the details of the mortgages offered to them by banks. If fixed-rate mortgages rise by just 10bp, that reduces their market share by more than 10 percentage points. Though they may not know it, mortgage buyers turn out to be incredibly sophisticated financial consumers — at least, they certainly act as though they are.

Now, thanks to Christian Menegatti, I’ve found another paper, this time by Tomasz Piskorski and Alexei Tchistyi of NYU. This one shows that the explosion in option-ARMs and other exotic mortgages actually makes perfect sense, from an economic point of view:

This paper studies optimal mortgage design… We show that the optimal allocation can be implemented using either a combination of an interest only mortgage with a home equity line of credit or an option adjustable rate mortgage. Under the optimal contracts, mortgage payments and default rates are higher when the market interest rate is high. However, borrowers benefit from low mortgage payments and low default rates when the market interest rate is low. Thus, our analysis provides theoretical evidence that these alternative mortgages, which have recently generated great controversy, can benefit both lenders and borrowers.

In other words, maybe the very low default rates of the past were actually economically suboptimal. I’m sure that the default rate on 2006-vintage subprime loans has swung the pendulum too far in the opposite direction. But let’s blame underwriting standards for that, not the structure of the underlying mortgages.

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