The subprime mortgage crisis: irrational exuberance or rational error?
AbstractWe 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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Bibliographic InfoArticle provided by Federal Reserve Bank of San Francisco in its journal Proceedings.
Volume (Year): (2009)
Issue (Month): Jan ()
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