Mortgage choice, house price externalities, and the default rate

We study the pathways by which borrowers and lenders influence house prices and default rates via their choices and offerings of fixed-rate and adjustable-rate mortgage products (FRMs and ARMs) in a two-period setting. We extend previous literature on mortgage choice as a tool for borrower risk screening under asymmetric information by incorporating house price externalities. The novelty in our setup is that house prices in the second period are negatively affected by the first-period default rate. We show that when these negative externalities are large, lenders may benefit by offering a lower ARM rate. This outcome, in turn, influences the likelihood of a separating equilibrium in which high-risk (low-risk) borrowers choose ARMs (FRMs) relative to a pooling equilibrium in which both high-risk and low-risk borrowers receive the same contract. When the impact of the negative house price externalities is small, it is more likely that lenders will offer pooling contracts; however, when the impact of the house price externalities is large, it is more likely that lenders will offer separating contracts. We also compare the equilibrium default rates across different contract offerings and find that when the negative house price externalities are large, the pooling FRM contract or the separating contract tends to offer the lowest default rate; however, when the negative house price externalities are small, the pooling ARM contract may result in the lowest default rate.