Making sense of the subprime crisis.

ABSTRACT Should market participants have anticipated the large increase in home foreclosures in 2007 and 2008? Most of these foreclosures stemmed from mortgage loans originated in 2005 and 2006, raising suspicions that lenders originated many extremely risky loans during this period. We show that although these loans did carry extra risk factors, particularly increased leverage, reduced underwriting standards alone cannot explain the dramatic rise in foreclosures. We also investigate whether market participants underestimated the likelihood of a fall in home prices or the sensitivity of foreclosures to falling prices. We show that given available data, they should have understood that a significant price drop would raise foreclosures sharply, although loan-level (as opposed to ownership-level) models would have predicted a smaller rise than occurred. Analyst reports and other contemporary discussions reveal that analysts generally understood that falling prices would have disastrous consequences but assigned that outcome a low probability.

**********

Had market participants anticipated the increase in defaults on subprime mortgages originated in 2005 and 2006, the nature and extent of the current financial market disruptions would be very different. Ex ante, investors in subprime mortgage-backed securities (MBSs) would have demanded higher returns and greater capital cushions. As a result, borrowers would not have found credit as cheap or as easy to obtain as it became during the subprime credit boom of those years. Rating agencies would have reacted similarly, rating a much smaller fraction of each deal investment grade. As a result, the subsequent increase in foreclosures would have been significantly smaller, with fewer attendant disruptions in the housing market, and investors would not have suffered such outsized, and unexpected, losses. To make sense of the subprime crisis, one needs to understand why, when accepting significant exposure to the creditworthiness of subprime borrowers, so many smart analysts, armed with advanced degrees, data on the past performance of subprime borrowers, and state-of-the-art modeling technology, did not anticipate that so many of the loans they were buying, either directly or indirectly, would go bad.

Our bottom line is that the problem largely had to do with expectations about home prices. Had investors known the future trajectory of home prices, they would have predicted large increases in delinquency and default and losses on subprime MBSs roughly consistent with what has occurred. We show this by using two different methods to travel back to 2005, when the subprime market was still thriving, and look forward from there. The first method is to forecast performance using only data available in 2005, and the second is to look at what market participants wrote at the time. The latter, "narrative" analysis provides strong evidence against the claim that investors lost money because they purchased loans that, because they were originated by others, could not be evaluated properly.

Our first order of business, however, is to address the more basic question of whether the subprime mortgages that defaulted were themselves unreasonable ex ante--an explanation commonly offered for the crisis. We show that the problem loans, most of which were originated in 2005 and 2006, were not that different from loans made earlier, which had performed well despite carrying a variety of serious risk factors. That said, we document that loans in the 2005-06 cohort were riskier, and we describe in detail the dimensions along which risk increased. In particular, we find that borrower leverage increased and, further, did so in a way that was relatively opaque to investors. However, we also find that the change in the mix of mortgages originated is too slight to explain the huge increase in defaults. Put simply, the average default rate on loans originated in 2006 exceeds the default rate on the riskiest category of loans originated in 2004.

We then turn to the role of the collapse in home price appreciation (HPA) that started in the spring of 2006. (1) To have invested large sums in subprime mortgages in 2005 and 2006, lenders must have expected either that HPA would remain high (or at least not collapse) or that subprime defaults would be insensitive to a big drop in HPA. More formally, letting f represent foreclosures, p prices, and t time, we can decompose the growth in foreclosures over time, df/dt, into a part corresponding to the sensitivity of foreclosures to price changes and a part reflecting the change in prices over time:

df/dt = df/dp x dp/dt.