Many homeowners cash-out refinanced in concert to extract equity from their properties during the run-up in U.S. house prices. We demonstrate that the risk characteristics of first-lien mortgages are systematically altered when second mortgages are behind them. Cash-out refinancing also effectively correlates homeowners' default decisions so that a large drop in house prices can result in almost all of these homeowners defaulting together. In this case, even the most senior tranches of

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... d financial products collateralized by first-lien mortgages may no longer be protected from default losses. When a collateralized debt obligation (CDO) structured under the assumption that homeowners cannot cash-out refinance is subsequently confronted by data generated by homeowners with "secret" seconds, the CDO's resultant performance is broadly consistent with the magnitude of CDO downgrades observed after the bursting of the U.S. housing bubble. By contrast, our results are not consistent with the argument that the observed downgrades occurred because the severity of the U.S. housing market downturn was underestimated by credit rating agencies.