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The risk-Shifting Hypothesis : Evidence from Subprime Originations

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

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 Toulouse School of Economics (TSE) in its series TSE Working Papers with number 11-279.

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Date of creation: Aug 2011
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Handle: RePEc:tse:wpaper:25604
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