Atlanta Fed Economist Examines the Subprime Crisis
In hindsight, the risks of subprime mortgages are obvious. But in 2005 and 2006, an unprecedented number of these loans were originated, in large part because of their excellent performance in previous years during the housing market boom.
So why were market participants willing to increase their exposure to subprime mortgages? Did they underestimate the likelihood of the impending fall in house prices, or did their models fail to uncover the true sensitivity of foreclosures to lower house prices, perhaps because there was no experience in the data that included falling house prices and widespread subprime mortgage originations?
Given available data, market participants should have been able to understand that a significant fall in prices would cause a large increase in foreclosures, according to a recent Atlanta Fed working paper by Kris Gerardi, a staff research economist and assistant policy adviser, Andreas Lehnert, Shane M. Sherland, and Paul S. Willen.
"Had market participants anticipated the increase in defaults on subprime mortgages originated in 2005 and 2006, the nature and extent of the current financial market disruptions would be very different," the authors wrote.
House price expectations were key to understanding the issue
The authors noted that the average default rate on loans originated in 2006 exceeds the default rate on the riskiest category of loans originated in 2004, leading them to then focus on the fall in house price appreciation that began in the spring of 2006. "Lenders must either have expected that [house price appreciation] would remain high (or at least that house prices would not collapse), or have expected subprime defaults to be insensitive to a big drop in house prices," they wrote.
The shock of falling house prices
Instead, some analysts thought that the rate of house price appreciation would slow but that prices would continue to rise. The authors write that investors were focused on issues such as small differences in prepayment speeds that, in hindsight, appear of secondary importance to the credit losses stemming from a house price downturn. "When they did consider scenarios with house price declines, market participants as a whole appear to have correctly identified the subsequent losses," the paper said. "However, such scenarios were labeled as ‘meltdowns’ and ascribed very low probabilities."
March 30, 2009