Deconstructing a Mortgage Meltdown: A Methodology for Decomposing Underwriting Quality

26 Pages Posted: 29 May 2009

See all articles by Charles D. Anderson

Charles D. Anderson

University Financial Associates LLC

Dennis R. Capozza

Ross School of Business, University of Michigan

Robert Van Order

University of Michigan - Stephen M. Ross School of Business; University of Aberdeen

Date Written: May 29, 2009

Abstract

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 develop a methodology for decomposing the trend in mortgage performance in the national serviced portfolio into a part due to economic conditions and a part due to underwriting changes. The decomposition provides natural metrics or indices of underwriting quality and economic conditions. The results suggest that the recent mortgage debacle can be attributed about equally to each factor. The relaxation in observable credit standards is not monotonic. While the easing of important risk characteristics, like loan to value ratios, in the early 1990s was arguably deliberate, the negative effects of lower standards was masked by strong local and national economic conditions. After 2000, there was little change in observable loan characteristics; nevertheless, loan performance continued to erode even after controlling for the economic environment. We present evidence that the erosion in the latter period must have arisen from underwriting covariates that are typically unobservable to investors in securitizations. This evidence is consistent with the hypothesis that moral hazard in "non-agency" securitizations of mortgages, particularly subprime and Alt-A loans, caused underwriting risks to be mispriced.

Keywords: mortgage, default, subprime, underwriting, foreclosure, risk management

JEL Classification: E44, E47, G21

Suggested Citation

Anderson, Charles D. and Capozza, Dennis R. and Van Order, Robert, Deconstructing a Mortgage Meltdown: A Methodology for Decomposing Underwriting Quality (May 29, 2009). Available at SSRN: https://ssrn.com/abstract=1411782 or http://dx.doi.org/10.2139/ssrn.1411782

Charles D. Anderson

University Financial Associates LLC ( email )

343 S. Main St.
Ann Arbor, MI 48104
United States

Dennis R. Capozza (Contact Author)

Ross School of Business, University of Michigan ( email )

701 Tappan Street
Ann Arbor, MI MI 48109
United States
734 995 7271 (Phone)
734 629-0635 (Fax)

Robert Van Order

University of Michigan - Stephen M. Ross School of Business ( email )

701 Tappan Street
Ann Arbor, MI MI 48109
United States

University of Aberdeen

Dunbar Street
Aberdeen, Scotland AB24 3QY
United Kingdom

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