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The subprime mortgage crisis: irrational exuberance or rational error?

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  • Nikola Kojucharov
  • Clyde F. Martin
  • Robert F. Martin
  • Lili Xu
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    Abstract

    We present a model of the subprime market in which credit quality and loan performance are driven by a statistical process with idiosyncratic and aggregate shocks. Investors use portfolio performance to infer the weight of each shock. We show that low and stable default rates from 2002-2005 convinced investors that the aggregate shock weight was small. In late 2006, when default rates surged, the market collapsed abruptly as investors abandoned their low-weight beliefs. We examine various proposals to fix the mortgage market and find that policy intervention has limited effectiveness in our model.

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    File URL: http://www.frbsf.org/economics/conferences/0901/Kojucharov-Martin-Martin-Xu.pdf
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    Bibliographic Info

    Article provided by Federal Reserve Bank of San Francisco in its journal Proceedings.

    Volume (Year): (2009)
    Issue (Month): Jan ()
    Pages:

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    Handle: RePEc:fip:fedfpr:y:2009:i:jan:x:12

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    Related research

    Keywords: Subprime mortgage;

    References

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    1. Todd Sinai & Nicholas S. Souleles, 2003. "Owner-Occupied Housing as a Hedge Against Rent Risk," NBER Working Papers 9462, National Bureau of Economic Research, Inc.
    2. Morris A. Davis & Robert F. Martin, 2008. "Housing, home production, and the equity and value premium puzzles," International Finance Discussion Papers 931, Board of Governors of the Federal Reserve System (U.S.).
    3. Morris Davis & Jonathan Heathcote, 2004. "Housing and the business cycle," Finance and Economics Discussion Series 2004-11, Board of Governors of the Federal Reserve System (U.S.).
    4. Gervais, Martin, 2002. "Housing taxation and capital accumulation," Journal of Monetary Economics, Elsevier, vol. 49(7), pages 1461-1489, October.
    5. Kristopher Gerardi & Adam Hale Shapiro & Paul S. Willen, 2007. "Subprime outcomes: risky mortgages, homeownership experiences, and foreclosures," Working Papers 07-15, Federal Reserve Bank of Boston.
    6. L. Randall Wray, 2008. "Lessons from the Subprime Meltdown," Challenge, M.E. Sharpe, Inc., vol. 51(2), pages 40-68, March.
    7. Jan Kregel, 2008. "Minsky’s Cushions of Safety: Systemic Risk and the Crisis in the U.S. Subprime Mortgage Market," Economics Public Policy Brief Archive ppb_93, Levy Economics Institute, The.
    8. Diaz-Serrano, Luis, 2005. "Income volatility and residential mortgage delinquency across the EU," Journal of Housing Economics, Elsevier, vol. 14(3), pages 153-177, September.
    9. Yuliya Demyanyk & Otto Van Hemert, 2008. "Understanding the subprime mortgage crisis," Proceedings, Federal Reserve Bank of Chicago, issue May, pages 171-192.
    10. Sanford J Grossman & Guy Laroque, 2003. "Asset Pricing and Optimal Portfolio Choice in the Presence of Illiquid Durable Consumption Goods," Levine's Working Paper Archive 618897000000000803, David K. Levine.
    11. Kau, James B, et al, 1993. "Option Theory and Floating-Rate Securities with a Comparison of Adjustable- and Fixed-Rate Mortgages," The Journal of Business, University of Chicago Press, vol. 66(4), pages 595-618, October.
    12. Benjamin J. Keys & Tanmoy Mukherjee & Amit Seru & Vikrant Vig, 2010. "Did Securitization Lead to Lax Screening? Evidence from Subprime Loans," The Quarterly Journal of Economics, MIT Press, vol. 125(1), pages 307-362, February.
    13. Lambrecht, Bart M & Perraudin, William R M & Satchell, Steven, 2003. " Mortgage Default and Possession under Recourse: A Competing Hazards Approach," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 35(3), pages 425-42, June.
    14. Robert F. Martin, 2003. "Consumption, durable goods, and transaction costs," International Finance Discussion Papers 756, Board of Governors of the Federal Reserve System (U.S.).
    15. Cox, John C & Ingersoll, Jonathan E, Jr & Ross, Stephen A, 1985. "An Intertemporal General Equilibrium Model of Asset Prices," Econometrica, Econometric Society, vol. 53(2), pages 363-84, March.
    16. Kau, James B, et al, 1992. "A Generalized Valuation Model for Fixed-Rate Residential Mortgages," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 24(3), pages 279-99, August.
    17. Marjorie Flavin & Takashi Yamashita, 2002. "Owner-Occupied Housing and the Composition of the Household Portfolio," American Economic Review, American Economic Association, vol. 92(1), pages 345-362, March.
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