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The risk-Shifting Hypothesis

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  • Landier, Augustin
  • Sraer, David
  • Thesmar, David

Abstract

Using loan level data, we provide evidence consistent with risk-shifting in the lending behavior of a large subprime mortgage originator { New Century Financial Corporation { starting in 2004. This change follows the monetary policy tightening implemented by the Fed in the spring of 2004, which resulted in an adverse shock to the large portfolio of loans New Century was holding for investment. New Century reacted to this shock by massively resorting to deferred amortization loan contracts (\interest-only" loans). We show that these loans were not only riskier, but also that their returns were by design more sensitive to real estate prices than standard contracts. New Century was thus financing projects with a high beta on its own survival, as predicted by a standard model of portfolio selection in financial distress. Our findings shed new light on the relationship between monetary policy and risk taking by financial institutions. They also contribute to better characterizing the type of risk taken by financially distressed firms.

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Paper provided by Institut d'Économie Industrielle (IDEI), Toulouse in its series IDEI Working Papers with number 699.

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Date of creation: Aug 2011
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Handle: RePEc:ide:wpaper:25603

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  1. Viral V. Acharya & Irvind Gujral & Nirupama Kulkarni & Hyun Song Shin, 2011. "Dividends and Bank Capital in the Financial Crisis of 2007-2009," NBER Working Papers 16896, National Bureau of Economic Research, Inc.
  2. Gadi Barlevy & Jonas D. M. Fisher, 2010. "Mortgage choices and housing speculation," Working Paper Series WP-2010-12, Federal Reserve Bank of Chicago.
  3. Bostic, Raphael W. & Engel, Kathleen C. & McCoy, Patricia A. & Pennington-Cross, Anthony & Wachter, Susan M., 2008. "State and local anti-predatory lending laws: The effect of legal enforcement mechanisms," Journal of Economics and Business, Elsevier, vol. 60(1-2), pages 47-66.
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Cited by:
  1. Giovanni Dell'Ariccia, 2012. "Property Prices and Bank Risk-taking," RBA Annual Conference Volume, in: Alexandra Heath & Frank Packer & Callan Windsor (ed.), Property Markets and Financial Stability Reserve Bank of Australia.
  2. Samuel G. Hanson & Jeremy C. Stein, 2012. "Monetary policy and long-term real rates," Finance and Economics Discussion Series 2012-46, Board of Governors of the Federal Reserve System (U.S.).

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