Why Did So Many People Make So Many Ex Post Bad Decisions? The Causes of the Foreclosure Crisis

Christopher L. Foote, Kristopher S. Gerardi, and Paul S. Willen
Working Paper 2012-7
May 2012

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We present 12 facts about the mortgage crisis. We argue that the facts refute the popular story that the crisis resulted from finance industry insiders deceiving uninformed mortgage borrowers and investors. Instead, we argue that borrowers and investors made decisions that were rational and logical given their ex post overly optimistic beliefs about house prices. We then show that neither institutional features of the mortgage market nor financial innovations are any more likely to explain those distorted beliefs than they are to explain the Dutch tulip bubble 400 years ago. Economists should acknowledge the limits of our understanding of asset price bubbles and design policies accordingly.

JEL classification: D14, D18, D53, D82, G01, G02, G38

Key words: financial crisis, mortgage, foreclosure, asymmetric information, mortgage-backedsecurity (MBS), collaterized debt obligation (CDO)

This paper was prepared for the conference "Rethinking Finance: New Perspectives on the Crisis," organized by Alan Blinder, Andy Lo, and Robert Solow and sponsored by the Russell Sage and Century Foundations. The authors thank Alberto Bisin, Ryan Bubb, Scott Frame, Jeff Fuhrer, Andreas Fuster, Anil Kashyap, Andreas Lehnert, and Bob Triest for helpful discussions and comments. 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 Christopher L. Foote, Research Department, Federal Reserve Bank of Boston, 600 Atlantic Avenue, Boston, MA 02210, 617-973-3077, chris.foote@bos.frb.org; Kristopher S. Gerardi, Research Department, Federal Reserve Bank of Atlanta, 1000 Peachtree Street, N.E., Atlanta, GA 30309-4470, 404-498-8561, kristopher.gerardi@atl.frb.org; or Paul S. Willen, Research Department, Federal Reserve Bank of Boston, 600 Atlantic Avenue, Boston, MA 02210, 617-973-3149, paul.willen@bos.frb.org.

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