Leverage and the Foreclosure Crisis

70 Pages Posted: 17 Aug 2013

See all articles by Dean Corbae

Dean Corbae

University of Wisconsin - Madison

Erwan Quintin

Federal Reserve Bank of Dallas

Date Written: August 2013

Abstract

How much of the recent rise in foreclosures can be explained by the large number of high-leverage mortgage contracts originated during the housing boom? We present a model where heterogeneous households select from a set of mortgage contracts and choose whether to default on their payments given realizations of income and housing price shocks. The set of mortgage contracts consists of loans with high downpayments and loans with low downpayments. We run an experiment where the use of low downpayment loans is initially limited by payment-to-income requirements but then becomes unrestricted for 8 years. The relaxation of approval standards causes homeownership rates, high-leverage originations and the frequency of high interest rate loans to rise much like they did in the US between 1998-2006. When home values fall by the magnitude observed in the US from 2007-08, default rates increase by over 180% as they do in the data. Two distinct counterfactual experiments where approval standards remain the same throughout suggest that the increased availability of high-leverage loans prior to the crisis can explain between 40% to 65% of the initial rise in foreclosure rates. Furthermore, we run policy experiments which suggest that recourse could have had significant dampening effects during the crisis.

Suggested Citation

Corbae, Dean and Quintin, Erwan, Leverage and the Foreclosure Crisis (August 2013). NBER Working Paper No. w19323, Available at SSRN: https://ssrn.com/abstract=2311572

Dean Corbae (Contact Author)

University of Wisconsin - Madison ( email )

716 Langdon Street
Madison, WI 53706-1481
United States

Erwan Quintin

Federal Reserve Bank of Dallas ( email )

PO Box 655906
Dallas, TX 75265-5906
United States

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