Making Sense of the Subprime Crisis

74 Pages Posted: 13 Feb 2009

See all articles by Kristopher Gerardi

Kristopher Gerardi

Federal Reserve Bank of Atlanta

Andreas Lehnert

Board of Governors of the Federal Reserve System

Shane Sherlund

Board of Governors of the Federal Reserve System

Paul Willen

Federal Reserve Bank of Boston - Research Department; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: December 22, 2008

Abstract

This paper explores the question of whether market participants could have or should have anticipated the large increase in foreclosures that occurred in 2007 and 2008. Most of these foreclosures stem from loans originated in 2005 and 2006, leading many to suspect that lenders originated a large volume of extremely risky loans during this period. However, the authors show that while loans originated in this period did carry extra risk factors, particularly increased leverage, underwriting standards alone cannot explain the dramatic rise in foreclosures. Focusing on the role of house prices, the authors ask whether market participants underestimated the likelihood of a fall in house prices or the sensitivity of foreclosures to house prices. The authors show that, given available data, market participants should have been able to understand that a significant fall in prices would cause a large increase in foreclosures, although loan-level (as opposed to ownership-level) models would have predicted a smaller rise than actually occurred. Examining analyst reports and other contemporary discussions of the mortgage market to see what market participants thought would happen, the authors find that analysts, on the whole, understood that a fall in prices would have disastrous consequences for the market but assigned a low probability to such an outcome.

JEL Classification: D11, D12, G21

Suggested Citation

Gerardi, Kristopher S. and Lehnert, Andreas and Sherlund, Shane and Willen, Paul S., Making Sense of the Subprime Crisis (December 22, 2008). FRB of Boston Public Policy Discussion Paper No. 09-1, Available at SSRN: https://ssrn.com/abstract=1341853 or http://dx.doi.org/10.2139/ssrn.1341853

Kristopher S. Gerardi

Federal Reserve Bank of Atlanta ( email )

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Andreas Lehnert

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States
202-452-3325 (Phone)
202-263-4852 (Fax)

Shane Sherlund

Board of Governors of the Federal Reserve System ( email )

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

Paul S. Willen (Contact Author)

Federal Reserve Bank of Boston - Research Department ( email )

600 Atlantic Avenue
Boston, MA 02210
United States

National Bureau of Economic Research (NBER)

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Cambridge, MA 02138
United States

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