Federal Reserve Bank of Philadelphia

views expressed in this paper are those of the authors and do not necessarily reflect those of the Federal Reserve Bank of Philadelphia or of the Federal Reserve System. We develop a model of collaterized lending (mortgages) with the risk of default. The focus of our analysis is on the interaction between home price fluctuations in local housing markets (metropoli-tan areas) and the frequency of mortgage defaults. There are three distinguishing features of our model. First, default on mortgages occur only when there is a fall in the value of local housing stock and a borrower’s current earnings is low. Second, mortgages are priced taking into account household risk characteristics and the amount put forward as downpayment (which can be freely chosen). Third, the price of housing as well as mortgages is affected by a city-specific (aggregate) shock. Preliminary results indicate that if households have high discount factors (low discount rates) and rational expectations, the possibility of capital loss or gain on housing leads to offsetting movements in downpayments, with little or no change in equilibrium default frequency