Systemic risk and the refinancing ratchet effect
Name
Lo_Systemic risk.pdf
Size
1.29 MB
Format
Adobe PDF
Checksum (MD5)
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Author(s)
Khandani, Amir E.
Lo, Andrew W
Merton, Robert
Date Issued
November 2012
Journal
Journal of Financial Economics
Publisher
Elsevier
Citation
Khandani, Amir E.; Lo, Andrew W. and Merton, Robert C. “Systemic Risk and the Refinancing Ratchet Effect.” Journal of Financial Economics 108, no. 1 (April 2013): 29–45. © 2012 Elsevier B.V.
Version
Author's final manuscript
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.
MIT Department
Massachusetts Institute of Technology. Department of Electrical Engineering and Computer Science
Sloan School of Management
Sloan School of Management. Laboratory for Financial Engineering
Terms of Use
Creative Commons Attribution-NonCommercial-NoDerivs License
Persistent DSpace Link
DOI of Published Version
https://doi.org/10.1016/j.jfineco.2012.10.007
