NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Systemic Risk and the Refinancing Ratchet Effect

Amir E. Khandani, Andrew W. Lo, Robert C. Merton

NBER Working Paper No. 15362
Issued in September 2009
NBER Program(s):   AP   EFG

The confluence of three trends in the U.S. residential housing market---rising home prices, declining interest rates, and near-frictionless refinancing opportunities---led to vastly increased systemic risk in the financial system. Individually, each of these trends is benign, but when they occur simultaneously, as they did over the past decade, they impose an unintentional synchronization of homeowner leverage. This synchronization, coupled with the indivisibility of residential real estate that prevents homeowners from deleveraging when property values decline and homeowner equity deteriorates, conspire to create a "ratchet" effect in which homeowner leverage is maintained or increased during good times without the ability to decrease leverage during bad times. If refinancing-facilitated homeowner-equity extraction is sufficiently widespread---as it was during the years leading up to the peak of the U.S. residential real-estate market---the inadvertent coordination of leverage during a market rise implies higher correlation of defaults during a market drop. To measure the systemic impact of this ratchet effect, we simulate the U.S. housing market with and without equity extractions, and estimate the losses absorbed by mortgage lenders by valuing the embedded put-option in non-recourse mortgages. Our simulations generate loss estimates of $1.5 trillion from June 2006 to December 2008 under historical market conditions, compared to simulated losses of $280 billion in the absence of equity extractions.

download in pdf format
   (1395 K)

email paper

A non-technical summary of this paper is available in the December 2009 NBER digest.  You can sign up to receive the NBER Digest by email.

This paper is available as PDF (1395 K) or via email.

Machine-readable bibliographic record - MARC, RIS, BibTeX

Document Object Identifier (DOI): 10.3386/w15362

Published: Khandani, Amir E. & Lo, Andrew W. & Merton, Robert C., 2013. "Systemic risk and the refinancing ratchet effect," Journal of Financial Economics, Elsevier, vol. 108(1), pages 29-45. citation courtesy of

Users who downloaded this paper also downloaded these:
Gray, Merton, and Bodie w13607 New Framework for Measuring and Managing Macrofinancial Risk and Financial Stability
Billio, Getmansky, Lo, and Pelizzon w16223 Econometric Measures of Systemic Risk in the Finance and Insurance Sectors
Allen, Babus, and Carletti w16177 Financial Connections and Systemic Risk
Battiston, Delli Gatti, Gallegati, Greenwald, and Stiglitz w15611 Liaisons Dangereuses: Increasing Connectivity, Risk Sharing, and Systemic Risk
Chan, Getmansky, Haas, and Lo w11200 Systemic Risk and Hedge Funds
 
Publications
Activities
Meetings
NBER Videos
Data
People
About

Support
National Bureau of Economic Research, 1050 Massachusetts Ave., Cambridge, MA 02138; 617-868-3900; email: info@nber.org

Contact Us