Adjustable and fixed rate mortgages as a screening mechanism for default risk

This paper studies how borrowers with different levels of default risk woul d self-select between fixed rate mortgages (FRMs) and adjustable rate mortg ages (ARMs). We show that under asymmetric information. where the risk type of a however is private information to the burrower and not known by the l ender, the unique equilibrium may be a separating equilibrium in which the high-risk (low-risk) borrowers choose ARMs (FRM's). Thus, the borrower's mo rtgage choice will serve as a signal of default risk, enabling lenders to s creen high-risk and low-risk borrowers. It is possible for the separating e quilibrium to yield positive economic profits for lenders in a competitive market. It is also possible to have a unique pooling equilibrium where all borrowers choose either FRMs or ARMs. The model implies that an increase in the proportion of high risks will increase the likelihood of a separating equilibrium where both mortgage types are offered. Also. a uniform downward shift in the expected change in the interest rate or an increase in borrow ers' current or future incomes make ARMs more attractive for both types of borrowers. (C) 2000 Academic Press.