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Dealing with Adverse Selection in the Mortgage Market

Posted on March 29, 2008

Suppose that a bank calculates that the net value of the mortgage to the bank as a fraction of its principal is equal to four years' interest minus the chance of default: = 4r - d And suppose that the homeowners and homebuyers who come to the bank have a chance of default which is: d = 15% + 20r2 Then bank profits expected from a typical homeowner and home buyer are: = 4r - 20r2 - 15% Which means that a bank can make profits as long as: 5% r 15% And if there are a bunch of competitive banks, and if homeowners can comparison shop, competition will push the interest rate down to 5% and a...

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default rate , housing , interest rates