The Inevitability of Market-Wide Underpricing of Mortgage Default Risk

Lenders are frequently accused of mispricing the put option imbedded in non-recourse lending (Herring and Wachter, 1999 and 2003). Prior research (Pavlov and Wachter, 2004) shows one lender's incentives to underprice. Here we identify the conditions for a market-wide underpricing equilibrium. We demonstrate that in a market with many players, given sufficient time, a race to the bottom and market-wide mispricing are inevitable. Underpricing occurs because bank managers and shareholders exploit mis-priced deposit insurance. We show that the probability of the underpricing equilibrium increases with time since the previous market crash and that the more volatile the underlying asset market, the more likely it is subject to underpricing