Why Did So Many Subprime Borrowers Default During the Crisis: Loose Credit or Plummeting Prices?

65 Pages Posted: 27 Sep 2015

See all articles by Christopher Palmer

Christopher Palmer

MIT Sloan; National Bureau of Economic Research (NBER)

Date Written: September 24, 2015

Abstract

The surge in subprime mortgage defaults during the Great Recession triggered trillions of dollars of losses in the financial sector and accounted for more than 50% of foreclosures at the height of the crisis. In particular, subprime mortgages originated in 2006-2007 were three times more likely to default within three years than mortgages originated in 2003-2004. In the ensuing years of debate, many have argued that this pattern across cohorts represents a deterioration in lending standards over time. I confirm this important channel empirically and quantify the relative importance of an alternative hypothesis: later cohorts defaulted at higher rates in large part because house price declines left them more likely to have negative equity. Using comprehensive loan-level data that includes much of the recovery period, I find that changing borrower and loan characteristics can explain up to 40% of the difference in cohort default rates, with the remaining heterogeneity across cohorts caused by local house-price declines. To account for the endogeneity of prices — especially that price declines themselves could have been caused by subprime lending — I instrument for house price changes with long-run regional variation in house-price cyclicality. Control-function results confirm that price declines unrelated to the credit expansion causally explain the majority of the disparity in cohort performance. Counterfactual simulations show that if 2006 borrowers had faced the price paths that the average 2003 borrower did, their annual default rate would have dropped from 12% to 5.6%.

Keywords: Great Recession, Mortgage Finance, Foreclosure Crisis, Subprime Lending, Negative Equity, Hazard Model Control Function

JEL Classification: G01, G21, R31, R38

Suggested Citation

Palmer, Christopher, Why Did So Many Subprime Borrowers Default During the Crisis: Loose Credit or Plummeting Prices? (September 24, 2015). Available at SSRN: https://ssrn.com/abstract=2665762 or http://dx.doi.org/10.2139/ssrn.2665762

Christopher Palmer (Contact Author)

MIT Sloan ( email )

77 Massachusetts Avenue
Cambridge, MA 02139-4307
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Register to save articles to
your library

Register

Paper statistics

Downloads
444
Abstract Views
2,170
rank
66,311
PlumX Metrics