The relationship between the recent boom and the current delinquencies in subprime mortgages

giovannidellariccia0, denizigan0, luclaeven0, Mon, 02/04/2008

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Over the last decade, the market for mortgage-backed securities has expanded dramatically, evolving from a small niche segment to a major portion of the overall U.S. mortgage market. The authors of CEPR DP6683 study the relationship between this recent boom and current delinquencies in the subprime mortgage market. Specifically, they analyze the extent to which this relationship can be explained by a decline in credit standards and excessive risk taking by lenders that is unrelated to improvements in underlying economic fundamentals.

The authors use data from over 50 million individual loan applications combined with information on local and national economic variables. The findings suggest that current mortgage delinquencies appear related to past credit growth. In particular, delinquency rates rose more sharply in areas that experienced larger increases in the number and volume of originated loans. While limited to a relatively narrow segment of the market, the subprime boom did share the characteristics often associated with aggregate boom-bust credit cycles; these include financial innovation (securitization), changes in market structure, fast rising house prices, and ample aggregate liquidity. There is evidence that all these factors were associated with the decline in lending standards. Furthermore, denial rates declined more in areas with a larger number of competitors and with more pronounced housing booms. Finally, easy monetary conditions seem to have played a role, with the cycle in lending standards mimicking that in the Federal Fund rate.

Overall, in the subprime mortgage market most of these effects appear to be stronger and more significant than in the prime mortgage market, where loan decisions seem to be more closely related to economic fundamentals. The subprime mortgage market provides an almost ideal testing ground for theories of intermediation based on asymmetric information as indeed subprime borrowers are generally riskier, more heterogeneous, and have shorter or worse credit histories (if any) than their prime counterparts. The paper further provides hints on the potential effects of monetary policy on banks’ risk-taking, with low interest rates affecting lending standards both directly and through their effect on real estate prices.

DP6683 Credit Booms and Lending Standards: Evidence From The Subprime Mortgage Market

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URL:  http://www.cepr.org/pubs/new-dps/dplist.asp?dpno=6683.asp

Topics:  Financial markets

Tags:  mortgages, credit boom, financial accelerators, lending standards, moral hazard, subprime loans

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