Allowing Underwater Borrowers to Refinance Could Improve Investors’ Sharpe Ratio

Consider borrowers with 6 percent 30-year mortgages that are 20 percent underwater. Assume that the probability that any one borrower will default in any one month is .2 percent, and that the cost of default to the lender conditional on default is 50 percent. Assume that at the end of five years, any remaining long balance [...]