Abstract
We develop a new model of the mortgage market where both borrowers and lenders can default. Risk tolerant savers (risk takers) act as intermediaries between risk averse depositors and impatient borrowers. The government provides mortgage guarantees and deposit insurance. Underpriced government guarantees lead to risky mortgage origination and excessive financial sector leverage. Mortgage crises frequently turn into financial crises and government bailouts due to the fragility of the intermediaries' balance sheets. Increasing the price of the mortgage guarantee crowds in the private sector, reduces financial fragility, leads to less and safer mortgage lending, lowers house prices, raises mortgage rates and risk-free interest rates. It also makes all agents in the economy strictly better off. The welfare gains are particularly large for the risk takers so that the private market solution increases wealth inequality.
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