The Risk-Shifting Hypothesis: Evidence from Subprime Originations.
Toulouse School of Economics
David Alexandre Sraer
University of California, Berkeley; Princeton University
HEC Paris - Finance Department
August 2, 2011
AFA 2012 Chicago Meetings Paper
Using loan level data, we provide evidence consistent with risk-shifting in the lend- ing behavior of a large subprime mortgage originator – New Century Financial Cor- poration – starting in 2004. This change follows the monetary policy tightening im- plemented 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 con- tracts. 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.
Number of Pages in PDF File: 48
Keywords: Risk Shifting, Subprime Mortgages, Monetary Tightening, Real Estate Risk
JEL Classification: G31, G32, E58
Date posted: March 17, 2011 ; Last revised: March 13, 2013
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