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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.

Suggested Citation

  • Landier, Augustin & Sraer, David & Thesmar, David, 2011. "The risk-Shifting Hypothesis," IDEI Working Papers 699, Institut d'Économie Industrielle (IDEI), Toulouse.
  • Handle: RePEc:ide:wpaper:25603
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    References listed on IDEAS

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    1. Gan, Jie, 2004. "Banking market structure and financial stability: Evidence from the Texas real estate crisis in the 1980s," Journal of Financial Economics, Elsevier, vol. 73(3), pages 567-601, September.
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    Cited by:

    1. Adrian, Tobias & Liang, J. Nellie, 2014. "Monetary policy, financial conditions, and financial stability," Staff Reports 690, Federal Reserve Bank of New York, revised 01 Dec 2016.
    2. Sergey Chernenko & Samuel G. Hanson & Adi Sunderam, 2014. "The Rise and Fall of Demand for Securitizations," NBER Working Papers 20777, National Bureau of Economic Research, Inc.
    3. Kogler, Michael, 2015. "Rewarding Prudence: Risk Taking, Pecuniary Externalities and Optimal Bank Regulation," Economics Working Paper Series 1512, University of St. Gallen, School of Economics and Political Science.

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