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Subprime Lending and Real Estate Prices

Andrey D. Pavlov

Simon Fraser University (SFU) - Finance Area

Susan M. Wachter

University of Pennsylvania - Wharton School, Department of Real Estate

October 7, 2009

Real Estate Economics, Forthcoming
U of Penn, Inst for Law & Econ Research Paper No. 09-36

This paper establishes a theoretical and empirical link between the use of aggressive mortgage lending instruments, such as interest only, negative amortization or subprime, mortgages, and the underlying house prices. Such instruments, which come into existence through innovation or financial deregulation, allow more borrowing than otherwise would occur in previously affordability constrained markets. Within the context of a model with an endogenous rent-buy decision, we demonstrate that the supply of aggressive lending instruments temporarily increases the asset prices in the underlying market because agents find it more attractive to own or because their borrowing constraint is relaxed, or both. This result implies that the availability of aggressive mortgage lending instruments magnifies the real estate cycle and the effects of fundamental demand shocks. We empirically confirm the predictions of the model using recent subprime origination experience. In particular, we find that regions that receive a high concentration of aggressive lending instruments experience larger price increases and subsequent declines than areas with low concentration of such instruments. This result holds in the presence of various controls and instrumental variables.

Number of Pages in PDF File: 32

Keywords: housing, real property, mortgages, house prices, interest only loans, negative amortization, aggressive lending instruments, innovation, financial deregulation, empirical, underpriced credit, asset price inflation, market bubbles

JEL Classification: G21, K11

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Date posted: October 19, 2009  

Suggested Citation

Pavlov, Andrey D. and Wachter, Susan M., Subprime Lending and Real Estate Prices (October 7, 2009). Real Estate Economics, Forthcoming; U of Penn, Inst for Law & Econ Research Paper No. 09-36. Available at SSRN: http://ssrn.com/abstract=1489435

Contact Information

Andrey D. Pavlov
Simon Fraser University (SFU) - Finance Area ( email )
Burnaby, British Columbia V5A 1S6
604 291 5835 (Phone)
604 291 4920 (Fax)
Susan M. Wachter (Contact Author)
University of Pennsylvania - Wharton School, Department of Real Estate ( email )
The Wharton School
3620 Locust Walk
Philadelphia, PA 19104-6330
United States
215-898-6355 (Phone)
HOME PAGE: http://real.wharton.upenn.edu/~wachter/index.html

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