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Mortgage Put Options and Real Estate Markets


In this paper we offer direct evidence that financial intermediation does impact underlying asset markets. We develop a specific observable symptom of a banking system that underprices the put option imbedded in non-recourse asset-backed lending. Using a dataset for 19 countries and over 500 real estate investment trusts, we find that, following a negative demand shock, the “underpricing” economies experience far deeper asset market crashes than economies in which the put option is correctly priced.

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  1. See Allen (2001), Allen and Gale (1998, 1999) and Pavlov and Wachter (2004, 2006) for models that show how underpricing of the put option leads to inflated asset prices.

  2. See “Interagency Guidance on Nontraditional Mortgage Product Risks” (

  3. See for instance Smith et al. (2005) for a direct estimation of real estate values in Los Angeles. Other studies and popular articles on the fundamental real estate values include Case and Shiller (2003), Krainer and Wei (2004), Krugman (2005), Leamer (2002), McCarthy and Peach (2004), and Shiller (2005), Edelstein (2005) and Edelstein et al. (1999), among others.

  4. The lending spread also covers the bank’s operating costs, but these are relatively small and constant throughout the market cycle.

  5. If investors are diversified, only covariance with the overall economy affects the price of the asset. (see for instance Sharpe 1964). Even if the fortunes of real estate markets have an impact on the overall economy, changes in asset volatility will have a smaller, second-order effect on the asset price when compared to the effect on an underpriced option to default.

  6. The price impact of real estate volatility changes through the covariance with the overall market are likely to be far smaller than the impact through changing the value of the option to default.

  7. World Bank World Economic Indicators CD-ROM (2000).

  8. In fact, virtually all commercial loans contain substantial prepayment penalties, so the option to prepay is not worth very much.

  9. In addition to the deposit rate, one could use measures of the default spread based on the cost of capital for the lender or other risk-free securities, such as Treasuries. In this analysis we use deposit rates primarily because they are measured precisely and available for all countries in our sample.


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We thank John Clapp, Robert Edelstein, David Geltner, David Ling, the participants of the Cambridge-Maastricht-MIT real estate symposium and the Homer Hoyt Spring Meeting for valuable comments and suggestions. We thank Dr. Christopher Shun, CFP® of Menang Corporation, Malaysia, for insightful discussions related to this paper and the Global Property Research Indices used in this research. Andrey Pavlov gratefully acknowledges support from the Social Sciences and Humanities Research Council of Canada. All errors remain our own.

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Correspondence to Andrey Pavlov.

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Pavlov, A., Wachter, S. Mortgage Put Options and Real Estate Markets. J Real Estate Finance Econ 38, 89–103 (2009).

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  • Real estate bubble
  • Mortgage lending put options
  • Asian financial crisis


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