The Adjustable Balance Mortgage: Reducing the Value of the Put

We propose a new mortgage contract that endogenously captures the risk of house price declines to minimize default risk resulting from changes in the underlying asset value while still retaining contract rates near the cost of a standard fixed-rate mortgage. By reducing the role of the legal system in mitigating house price risk, the new mortgage reduces the negative externalities and social costs arising from defaults. In other words, the new mortgage minimizes the need to use the legal foreclosure system to deal with the economic risk of house price declines.