Amir E. Khandani, Andrew W. Lo, and Robert C. Merton
Systemic risk and the refinancing ratchet effect
Journal of Financial Economics | Volume 108, Issue 1 (Apr 2013), 29–45

A number of trends over the two decades leading to the financial crisis that started in 2007 made it much easier for homeowners to refinance their mortgages to take advantage of declining interest rates, increasing housing prices, or both. In Khandani-Lo-Merton (JFE 2013), we argue that during periods of rising home prices, falling interest rates, and increasingly competitive and efficient refinancing markets, cash-out refinancing acts like a ratchet: homeowner leverage increases incrementally as real-estate values appreciate, but cannot decrease incrementally as real-estate values decline. This self-synchronizing “ratchet effect” can create significant systemic risk in an otherwise geographically and temporally diverse pool of mortgages. We show that even in the absence of any dysfunctional behavior such as excessive risk-taking, fraud, regulatory forbearance, political intervention, and predatory borrowing and lending, large system-wide shocks can occur in the housing and mortgage markets. The mechanism behind this systemic risk is subtle and complex, arising from the confluence of three familiar and individually welfare-improving economic trends.

Our approach

To gauge the magnitude of the potential risk caused by the refinancing ratchet effect, we created a numerical simulation of the U.S. housing and mortgage markets that matches the size and growth of this market over the last few decades using data from 1919, because over 93% of homes in use today were built after 1919.

We modeled realistic heterogeneity in our simulations by incorporating geographical diversity in the rate of home price appreciation, diversity in initial purchase price of homes, as well as diversity in the types and size of mortgages used to purchase each home based on several data sources such as the 2007 American Housing Survey, the Federal Housing Finance Agency, and the Case-Shiller housing price indices. By following mortgages associated with each home and by specifying reasonable behavioral rules for the typical homeowner's equity extraction decision, we were able to match some of the major trends in this market over the past several decades. For example, as shown in Figure 1, our simulations can match the dramatic rise in outstanding total mortgages and cumulative equity extractions in the last two decades. (Cash-out refinancing takes place according to the base-case specification outlined in the JFE paper.)

1: Simulated and actual mortgage debt outstanding and cumulative equity extractions
In the top figure, the blue line are outstanding mortgages simulated under the calibrated uniform rule. The maroon line are the actual total mortgages outstanding from the Federal Reserve Flow-of-Funds Accounts. In the bottom figure, the blue line are cumulative equity extractions simulated under the calibrated uniform rule. The maroon line are the total mortgage liability series from Greenspan-Kennedy (OREP 2008).

Option-based evaluation of losses and risks

Armed with a properly calibrated simulation of the U.S. residential mortgage market, we turn to assessing the systemic risk posed by the refinancing ratchet effect. Given our assumption that all mortgages in our simulations are non-recourse loans—collateralized only by the value of the underlying real estate—the homeowner has a guarantee, or put option, that allows him to put or “sell” the home to the lender at the remaining value of the loan if the value of the home declines to below the outstanding mortgage.

As mortgages are placed in various structured products like collateralized mortgage obligations and then sold and re-sold to banks, asset management firms, or government-sponsored enterprises (GSEs), the ultimate entities exposed to these guarantees may be masked. However, it is clear that all mortgage lenders must, in the aggregate, be holding the guarantees provided to all homeowners. To the extent that some owners may be liable for the deficiency in their collateral value through recourse, those owners share some of the burden of the loss caused by a decline in home prices. Therefore the estimated economic loss and various risk metrics should be viewed as the amount of economic loss or risk exposure for the lenders and the subset of borrowers that are legally held responsible via recourse in their mortgages.

Table 1 shows that the ratchet effect alone is capable of generating the magnitude of losses suffered by mortgage lenders during the Financial Crisis of 2007–2009, yielding $1.7 trillion in losses for mortgage-lending institutions since June 2006 compared to $330 billion in the case of no-equity extractions.

A benefit of using option-pricing technology for this calculation is that in addition to giving us a numerical value for the total economic loss, it provides us with general forward-looking risk measures based on the sensitivities of the value of mortgages' embedded put options to changes in the level or volatility of home prices. For example, as reported in Table 1, in the first quarter of 2005 we estimate that the aggregate value of all embedded put options would increase by $18.17 billion for each 1% drop in home prices. By the last quarter of 2008, this sensitivity almost doubled to $38.13 billion for each 1% drop in home values compared to only $7.42 billion in which no equity had been extracted. This increase is due to the large convexity, or gamma using option-based measures, in the value of embedded options. As reported in Table 1, we estimate that gamma was $573.79 million per 1% drop in home values in the first quarter of 2005, which increased to $801.13 million for each 1% drop in home values by the last quarter of 2008.

The size and increase in the gammas of these options indicate substantial non-linearity in the risk of the mortgage system that may need to be accounted for in systemic risk measurement and analysis. We estimate that the total value of the embedded put options in non-recourse mortgages would increase by approximately $70 to $80 billion for each 1% increase in home price volatility in the years leading up to the crisis—known as the options' “vega” —compared to only $10 to $15 billion for each 1% increase in home price volatility if no equity had been extracted.

1: The ratchet effect
No Cash-Out Cash-Out
Put Value Delta Gamma Vega Put Value Delta Gamma Vega
Mar-05 64.90 2.2 79 11 566.60 18 574 75
Jun-05 65.70 2.3 80 11 568.80 18 581 76
Sep-05 69.20 2.4 83 11 592.30 19 598 78
Dec-05 74.20 2.5 87 12 601.30 19 611 80
Mar-06 81.50 2.7 91 12 621.10 20 625 81
Jun-06 87.10 2.9 97 13 611.70 20 631 81
Sep-06 100.90 3.2 105 13 644.90 21 648 82
Dec-06 114.90 3.6 113 14 698.70 22 673 83
Mar-07 126.80 3.9 120 15 748.40 23 696 84
Jun-07 137.30 4.1 127 15 782.80 24 715 85
Sep-07 153.30 4.5 136 16 831.20 25 735 85
Dec-07 178.90 5.1 146 16 951.00 27 771 86
Mar-08 221.80 5.8 156 16 1,185.10 31 813 84
Jun-08 252.40 6.4 161 16 1,345.20 34 829 82
Sep-08 278.40 6.8 164 16 1,465.40 35 824 79
Dec-08 330.20 7.4 165 16 1,727.20 38 801 74
Simulated time series of the aggregate value and sensitivities of total guarantees extended to homeowners by mortgage lenders for cash-out and no-cash-out refinancing scenarios for each quarter from 2005Q1 to 2008Q4 (put values are in $billions, deltas are in $billions per 1% decline in home prices, gammas are in $millions per 1% decline in home prices, and vegas are in $billions per 1% increase in home price volatility). Cash-out refinancing takes place according to the base-case specification outlined in the JFE paper.

Solution to the refinancing ratchet effect

Indivisibility and sole ownership of residential real-estate are two special characteristics of this asset class that make addressing the ratchet effect particularly challenging. Because the owner is typically the sole equity holder in an owner-occupied residential property, it is difficult to bring incrementally additional capital in to reduce risk by issuing new equity. Therefore, the only option available to homeowners in a declining market is to sell their homes, recognize their capital losses, and move into less expensive properties that satisfy their desired loan-to-value (LTV) ratio which imposes enormous financial and psychological costs.

A simple remedy is to require all mortgages to be recourse loans. If all mortgages were recourse loans and borrowers had uncorrelated sources of income, the additional income of the borrowers would create an extra level of protection for the lenders and, therefore, distribute the risk in the mortgage system between lenders and borrowers more evenly. However, the legal procedure for foreclosure and obtaining a deficiency judgment is complex, varying greatly from state to state. For example, home mortgages are explicitly non-recourse in only 11 states. Even in certain populous states with recourse, such as Florida and Texas, generous homestead-exemption laws can make it virtually impossible for lenders to collect on deficiency judgments because borrowers can easily shield their assets.

For this reason, the losses and risks estimated using the methods discussed in this paper should be thought of as losses that can be passed to the borrowers to the extent that mortgage lenders have recourse and can obtain deficiency judgments against defaulting borrowers.


The fact that the refinancing ratchet effect arises only when three market conditions are simultaneously satisfied demonstrates that the recent financial crisis is subtle and may not be attributable to a single cause. Moreover, a number of the activities that gave rise to these three conditions are likely to be ones that we would not want to sharply curtail or outright ban because individually they are beneficial. While excessive risk-taking, overly aggressive lending practices, pro-cyclical regulations, and political pressures surely contributed to the recent problems in the U.S. housing market, our simulations show that even if all home-owners, lenders, investors, insurers, rating agencies, regulators, and policymakers behaved rationally, ethically, and with the purest of motives, financial crises could still occur. Therefore, we must acknowledge the possibility that no easy legislative or regulatory solutions may exist.

Titian (1488-1576). Diana and Actaeon. Italy, 1559.. Purchased from the Duke of Sutherland by the U.K. National Galleries in 2009 for $79.1 million. This was the companion piece to Diana and the Castillo shown and described above.