Subprime! Problems forseeable in 2005?

This won’t be much of a review, but I have come across a rather provocatively abstracted paper: Understanding the Subprime Mortgage Crisis, by Yuliya Demyanyk and Otto van Hemert, both of the Federal Reserve Board, dated February 29, 2008:

[abstract] Using loan-level data, we analyze the quality of subprime mortgage loans by adjusting their performance for differences in borrower characteristics, loan characteristics, and house price appreciation since origination. We find that the quality of loans deteriorated for six consecutive years before the crisis and that securitizers were, to some extent, aware of it. We provide evidence that the rise and fall of the subprime mortgage market follows a classic lending boom-bust scenario, in which unsustainable growth leads to the collapse of the market. Problems could have been detected long before the crisis, but they were masked by high house price appreciation between 2003 and 2005.

[Extract from conclusion] The decline in loan quality has been monotonic, but not equally spread among different types of borrowers. Over time, high-LTV borrowers became increasingly risky (their adjusted performance worsened more) compared to low-LTV borrowers. Securitizers seem to have been aware of this particular pattern in the relative riskiness of borrowers: We show that over time mortgage rates became more sensitive to the LTV ratio of borrowers. In 2001, for example, the premium paid by a high LTV borrower was close to zero. In contrast, in 2006 a borrower with a one standard deviation above-average LTV ratio paid a 30 basis point premium compared to an average LTV borrower.

In many respects, the subprime market experienced a classic lending boom bust scenario with rapid market growth, loosening underwriting standards, deteriorating loan performance, and decreasing risk premiums. Argentina in 1980, Chile in 1982, Sweden, Norway, and Finland in 1992, Mexico in 1994, Thailand, Indonesia, and Korea in 1997 all experienced the culmination of a boom-bust scenario, albeit in different economic settings.

Were problems in the subprime mortgage market apparent before the actual crisis showed signs in 2007? Our answer is yes, at least by the end of 2005. Using the data available only at the end of 2005, we show that the monotonic degradation of the subprime market was already apparent. Loan quality had been worsening for five consecutive years at that point. Rapid appreciation in housing prices masked the deterioration in the subprime mortgage market and thus the true riskiness of subprime mortgage loans. When housing prices stopped climbing, the risk in the market became apparent.

 

 

5 Responses to “Subprime! Problems forseeable in 2005?”

  1. […] paper Understanding the Subprime Mortgage Crisis by Yuliya S. Demyanyk and Otto Van Hemert has been previously discussed on PrefBlog, but it’s about to be published on a formal basis (forthcoming in the Review of Financial […]

  2. […] Update: For a review of what participants were thinking at the time, see Making sense of the subprime crisis. For more on subprime default experience, see Subprime! Problems forseeable in 2005? […]

  3. […] Update: For a review of what participants were thinking at the time, see Making sense of the subprime crisis. For more on subprime default experience, see Subprime! Problems forseeable in 2005? […]

  4. […] will be discussed extensively world-wide for the next hundred-odd years. Two posts of interest are Subprime! Problems forseeable in 2005? and FRBB: Bubbles […]

  5. […] is being criticized for not knowing in 2005 that there was a housing bubble. Was it forseeable? Some say yes. Some say no. What bugs me about the US is that they have so many smart guys doing all kinds of […]

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