Deconstructing the Subprime Debacle Using New Indices of Underwriting Quality and Economic Conditions: A First Look
33 Pages Posted: 15 Jul 2008
Date Written: July 15, 2008
We document that technical progress in originating and pricing mortgages has enabled a trend since 1979 toward more relaxed credit standards on mortgage lending, which is reflected in rising foreclosure rates. We then decompose annual variation in mortgage performance measured by share of loans entering foreclosure into a part due to economic conditions and a part due to underwriting changes. The decomposition provides natural metrics or indices of national underwriting quality and economic conditions. The results suggest that the recent subprime debacle can be attributed about equally to each factor. The deterioration since 1990 was marked by two periods. In the first, during the 1990s, there was a lowering of observable credit standards, like loan to value ratios. It was deliberate and related to the use of credit scores and the development of more sophisticated underwriting systems. The negative effects of eroding loan quality on foreclosures were to some extent masked by strong local and national economic conditions during this period. In the second period, after 2002, there was little change in observable loan characteristics like loan to value or credit history. This second period is associated with the rise of subprime and Alt-A markets but also with subprime and other "non-agency" securitization. Securitization induced moral hazard and a deterioration in underwriting standards that was not easily observed by investors in the securities.
Keywords: Mortgages, subprime, house prices, banking
JEL Classification: E44, E47, G21
Suggested Citation: Suggested Citation