Got Hurt for What You Paid? Revisiting Government Subsidy in the U.S. Mortgage Market

Abstract

Using a screening model with asymmetric information, I evaluate the positive and normative effects of the subsidized default insurance policy in the U.S. mortgage market. The model implies that the subsidy raises interest rates for eligible mortgages, which is contrary to conventional wisdom but is consistent with the empirical evidence in Zhao (2019 Zhao, Y. (2019). Evidence of government subsidy on mortgage rate and default: Revisited. Journal of Housing Research, 28(1), 23–49. https://doi.org/10.1080/10835547.2019.12092157[Taylor & Francis Online] , [Google Scholar]). Moreover, the model implies that the subsidy hurts borrowers it was intended to help, as well as raises the aggregate mortgage default rate. My article highlights the adverse impact of the subsidy on welfare and financial stability, and sheds light on the root cause of the global financial crisis. It also provides potentially useful reference to other countries that have (or are considering adopting) a mortgage subsidy mechanism similar to that in the US.