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Making sense of the subprime crisis

  • Kristopher S. Gerardi
  • Andreas Lehnert
  • Shane M. Sherlund
  • Paul S. Willen

This paper explores the question of whether market participants could have or should have anticipated the large increase in foreclosures that occurred in 2007 and 2008. Most of these foreclosures stem from loans originated in 2005 and 2006, leading many to suspect that lenders originated a large volume of extremely risky loans during this period. However, the authors show that while loans originated in this period did carry extra risk factors, particularly increased leverage, underwriting standards alone cannot explain the dramatic rise in foreclosures. Focusing on the role of house prices, the authors ask whether market participants underestimated the likelihood of a fall in house prices or the sensitivity of foreclosures to house prices. The authors show that, given available data, market participants should have been able to understand that a significant fall in prices would cause a large increase in foreclosures, although loan-level (as opposed to ownership-level) models would have predicted a smaller rise than actually occurred. Examining analyst reports and other contemporary discussions of the mortgage market to see what market participants thought would happen, the authors find that analysts, on the whole, understood that a fall in prices would have disastrous consequences for the market but assigned a low probability to such an outcome.

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Paper provided by Federal Reserve Bank of Boston in its series Public Policy Discussion Paper with number 09-1.

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Date of creation: 2009
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Handle: RePEc:fip:fedbpp:09-1
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  1. Charles Himmelberg & Christopher Mayer & Todd Sinai, 2005. "Assessing High House Prices: Bubbles, Fundamentals and Misperceptions," Journal of Economic Perspectives, American Economic Association, vol. 19(4), pages 67-92, Fall.
  2. Joseph G. Haubrich & Deborah Lucas, 2006. "Who holds the toxic waste? an investigation of CMO holdings," Proceedings 1014, Federal Reserve Bank of Chicago.
  3. Karl E. Case & Robert J. Shiller, 1987. "Prices of Single Family Homes Since 1970: New Indexes for Four Cities," NBER Working Papers 2393, National Bureau of Economic Research, Inc.
  4. Jonathan McCarthy & Richard W. Peach, 2004. "Are home prices the next "bubble"?," Economic Policy Review, Federal Reserve Bank of New York, issue Dec, pages 1-17.
  5. Morris A. Davis & Andreas Lehnert & Robert F. Martin, 2008. "The Rent-Price Ratio For The Aggregate Stock Of Owner-Occupied Housing," Review of Income and Wealth, International Association for Research in Income and Wealth, vol. 54(2), pages 279-284, 06.
  6. David K. Musto & Nicholas S. Souleles, 2005. "A Portfolio View of Consumer Credit," NBER Working Papers 11735, National Bureau of Economic Research, Inc.
  7. Lucas, Deborah & McDonald, Robert L., 2006. "An options-based approach to evaluating the risk of Fannie Mae and Freddie Mac," Journal of Monetary Economics, Elsevier, vol. 53(1), pages 155-176, January.
  8. Danis, Michelle A. & Pennington-Cross, Anthony, 2008. "The delinquency of subprime mortgages," Journal of Economics and Business, Elsevier, vol. 60(1-2), pages 67-90.
  9. Anthony Pennington-Cross & Giang Ho, 2010. "The Termination of Subprime Hybrid and Fixed-Rate Mortgages," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 38(3), pages 399-426.
  10. Deng, Yongheng & Gabriel, Stuart, 2006. "Risk-Based Pricing and the Enhancement of Mortgage Credit Availability among Underserved and Higher Credit-Risk Populations," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 38(6), pages 1431-1460, September.
  11. Joshua D. Coval & Jakub W. Jurek & Erik Stafford, 2009. "Economic Catastrophe Bonds," American Economic Review, American Economic Association, vol. 99(3), pages 628-66, June.
  12. Mark Doms & Fred Furlong & John Krainer, 2007. "Subprime mortgage delinquency rates," Working Paper Series 2007-33, Federal Reserve Bank of San Francisco.
  13. Coleman IV, Major & LaCour-Little, Michael & Vandell, Kerry D., 2008. "Subprime lending and the housing bubble: Tail wags dog?," Journal of Housing Economics, Elsevier, vol. 17(4), pages 272-290, December.
  14. Joshua Gallin, 2006. "The Long-Run Relationship between House Prices and Income: Evidence from Local Housing Markets," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 34(3), pages 417-438, 09.
  15. Christopher L. Foote & Kristopher Gerardi & Lorenz Goette & Paul S. Willen, 2008. "Subprime facts: what (we think) we know about the subprime crisis and what we don’t," Public Policy Discussion Paper 08-2, Federal Reserve Bank of Boston.
  16. Christopher L. Foote & Kristopher Gerardi & Paul S. Willen, 2008. "Negative equity and foreclosure: theory and evidence," Public Policy Discussion Paper 08-3, Federal Reserve Bank of Boston.
  17. 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.
  18. Yongheng Deng & John M. Quigley & Robert Van Order, . "Mortgage Terminations, Heterogeneity and the Exercise of Mortgage Options," Zell/Lurie Center Working Papers 322, Wharton School Samuel Zell and Robert Lurie Real Estate Center, University of Pennsylvania.
  19. 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.
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