Adverse Selection and Moral Hazard Effects in the Mortgage Market: An Empirical Analysis

Abstract

With imperfect information, prices may have sorting and incentive effects that confound the received theory of market behavior.' These effects are more likely to be observed in situations where transactions extend over a lengthy period of time, as in credit and labor markets. Hence, one may observe equilibrium credit rationing or equilibrium unemployment in labor markets, even though these markets are competitive and free of government regulation [7; 8]. In credit markets, higher interest rates may adversely sort good credit risks from bad credit risks. Similarly, higher interest rates may induce borrowers to invest in riskier projects and not to exercise due diligence in the minimization of risks (moral hazard). Either the adverse selection or the moral hazard effects can lead to a reduction in expected profits as the interest rate rises. The supply of loanable funds is an increasing function of expected profits. If expected profits decline over some interval of rising interest rates, then the supply of loanable funds will be concave and backward bending with regard to interest rates over that interval. Stiglitz and Weiss identify the interest rate at which the supply function bends backward as the bank-optimal interest rate [8, 394]. The purpose of this paper is to test the empirical implications drawn from the growing adverse selection and moral hazard literature in the home mortgage market. A recent citation search reveals that the Stiglitz and Weiss [8] paper has been cited over one hundred and fifty times in the last nine years. In his survey of the literature, Stiglitz notes that most of this derivative literature is theoretical and ... that the models . . . have not been the subject of extensive empirical testing [7, 42]. The paper is organized as follows. In section II we review the adverse selection and moral hazard literature, consider the characteristics peculiar to the mortgage market and identify the empirical implications. Section III gives our estimates for the empirical model of the mortgage market. Among other results we find that mortgage supply is a concave function of the rate of