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The subprime mortgage crisis: irrational exuberance or rational error?

Author

Listed:
  • Nikola Kojucharov
  • Clyde F. Martin
  • Robert F. Martin
  • Lili Xu

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.

Suggested Citation

  • Nikola Kojucharov & Clyde F. Martin & Robert F. Martin & Lili Xu, 2009. "The subprime mortgage crisis: irrational exuberance or rational error?," Proceedings, Federal Reserve Bank of San Francisco, issue Jan.
    • Handle: RePEc:fip:fedfpr:y:2009:i:jan:x:12
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    References listed on IDEAS

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