Selection, Leverage, and Default in the Mortgage Market

We ask whether the correlation between mortgage leverage and default is due to moral hazard (the causal effect of leverage) or adverse selection (ex-ante risky borrowers choosing larger loans). We separate these information asymmetries using a natural experiment resulting from (i) the unique contract structure of Option Adjustable-Rate Mortgages and (ii) the unexpected 2008 divergence of the indexes that determine interest rate adjustments. Moral hazard is responsible for 40% of the correlation, while adverse selection explains 60%. We construct and calibrate a simple model to show that optimal regulation of leverage must weigh default-prevention against market distortions due to adverse selection.