An Empirical Model of Subprime Mortgage Default from 2000 to 2007

61 Pages Posted: 15 Jan 2009 Last revised: 30 Jan 2009

See all articles by Patrick Bajari

Patrick Bajari

University of Michigan at Ann Arbor - Department of Economics; National Bureau of Economic Research (NBER)

Chenghuan Sean Chu

Federal Reserve Board of Governors

Minjung Park

University of Minnesota - Twin Cities - Department of Economics

Date Written: December 2008

Abstract

The turmoil that started with increased defaults in the subprime mortgage market has generated instability in the financial system around the world. To better understand the root causes of this financial instability, we quantify the relative importance of various drivers behind subprime borrowers' decision to default. In our econometric model, we allow borrowers to default either because doing so increases their lifetime wealth or because of short-term budget constraints, treating the decision as the outcome of a bivariate probit model with partial observability. We estimate our model using detailed loan-level data from LoanPerformance and the Case-Shiller home price index. According to our results, one main driver of default is the nationwide decrease in home prices. The decline in home prices caused many borrowers' outstanding mortgage liability to exceed their home value, and for these borrowers default can increase their wealth. Another important driver is deteriorating loan quality: The increase of borrowers with poor credit and high payment to income ratios elevates default rates in the subprime market. We discuss policy implications of our results. Our findings point to flaws in the securitization process that led to the current wave of defaults. Also, we use our model to evaluate alternative policies aimed at reducing the rate of default.

Suggested Citation

Bajari, Patrick and Chu, Chenghuan Sean and Park, Minjung, An Empirical Model of Subprime Mortgage Default from 2000 to 2007 (December 2008). NBER Working Paper No. w14625. Available at SSRN: https://ssrn.com/abstract=1327247

Patrick Bajari (Contact Author)

University of Michigan at Ann Arbor - Department of Economics ( email )

611 Tappan Street
Ann Arbor, MI 48109-1220
United States
734-763-5319 (Phone)

HOME PAGE: http://www-personal.umich.edu/~bajari/

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Chenghuan Sean Chu

Federal Reserve Board of Governors ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Minjung Park

University of Minnesota - Twin Cities - Department of Economics ( email )

271 19th Avenue South
Minneapolis, MN 55455
United States

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