The Impact of Credit Risk Mispricing on Mortgage Lending During the Subprime Boom

60 Pages Posted: 17 Jul 2019

See all articles by James A. Kahn

James A. Kahn

Yeshiva University; National Bureau of Economic Research (NBER)

Benjamin Kay

Board of Governors of the Federal Reserve System

Date Written: 2019-06-21

Abstract

We provide new evidence that credit supply shifts contributed to the U.S. subprime mortgage boom and bust. We collect original data on both government and private mortgage insurance premiums from 1999-2016, and document that prior to 2008, premiums did not vary across loans with widely different observable characteristics that we show were predictors of default risk. Then, using a set of post-crisis insurance premiums to fit a model of default behavior, and allowing for time-varying expectations about house price appreciation, we quantify the mispricing of default risk in premiums prior to 2008. We show that the flat premium structure, which necessarily resulted in safer mortgages cross-subsidizing riskier ones, produced substantial adverse selection. Government insurance maintained an even flatter premium structure even post-crisis, and consequently also suffered from adverse selection. But after 2008 it reduced its exposure to default risk through a combination of higher premiums and rationing at the extensive margin.

Keywords: Default Risk, Financial Crisis, Housing Finance, Mortgage Insurance

JEL Classification: E32, G21, E44

Suggested Citation

Kahn, James A. and Kay, Benjamin, The Impact of Credit Risk Mispricing on Mortgage Lending During the Subprime Boom (2019-06-21). FEDS Working Paper No. 2019-046. Available at SSRN: https://ssrn.com/abstract=3417742 or http://dx.doi.org/10.17016/FEDS.2019.046

James A. Kahn (Contact Author)

Yeshiva University ( email )

500 West 185th Street
New York, NY 10033
United States
212-340-7863 (Phone)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Benjamin Kay

Board of Governors of the Federal Reserve System ( email )

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

HOME PAGE: http://https://www.federalreserve.gov/econres/benjamin-s-kay.htm

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