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Atlanta Fed Working Papers


Making Sense of the Subprime Crisis

Kristopher S. Gerardi, Andreas Lehnert, Shane M. Sherland, and Paul S. Willen
Working Paper 2009-2
February 2009

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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 stemmed 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.

JEL classification: D11, D12, G21

Key words: subprime, foreclosure, house prices, underwriting standards


This paper was prepared for the Brookings Panel on Economic Activity held on September 11–12, 2008. The authors thank Debbie Lucas and Nick Souleles for excellent discussions, the Brookings panel and various other academic and nonacademic audiences for helpful comments, and the editors for their suggestions, advice, and patience. They also thank Christina Pinkston for valuable help programming the First American Loan Performance data. The views expressed here are the authors' and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors' responsibility.

Please address questions regarding content to Paul S. Willen (corresponding author), Senior Economist and Policy Adviser, Federal Reserve Bank of Boston, 600 Atlantic Avenue, Boston, MA 02210, 617-973-3149, paul.willen@bos.frb.org; Kristopher S. Gerardi, Research Economist and Assistant Policy Adviser, Research Department, Federal Reserve Bank of Atlanta, 1000 Peachtree Street, N.E., Atlanta, GA 30309-4470, 404-498-8561, kristopher.gerardi@atl.frb.org; Andreas Lehnert, Chief, Household and Real Estate Finance Section, Board of Governors of the Federal Reserve System, 20th & C Streets, N.W., Washington, D.C. 20551, 202-452-3325, andreas.lehnert@frb.gov; or Shane M. Sherlund, Senior Economist, Household and Real Estate Finance Section, Board of Governors of the Federal Reserve System, 20th & C Streets, N.W., Washington, D.C. 20551, 202-452-3589, shane.m.sherlund@frb.gov.

For further information, contact the Public Affairs Department, Federal Reserve Bank of Atlanta, 1000 Peachtree Street, N.E., Atlanta, Georgia 30309-4470, 404-498-8020.