The subprime mortgage market experienced explosive growth between 2001 and 2006. Angell and Rowley (2006) and Kiff and Mills (2007), among others, argue that this was facilitated by the development of private-label mortgage backed securities, which do not carry any kind of credit risk protection by the Government Sponsored Enterprises. Investors in search of higher yields kept increasing their demand for private-label mortgage-backed securities, which also led to sharp increases in the subprime share of the mortgage market (from around 8 percent in 2001 to 20 percent in 2006) and in the securitized share of the subprime mortgage market (from 54 percent in 2001 to 75 percent in 2006).
In this paper we show that during the dramatic growth of the subprime (securitized) mortgage market, the quality of the market deteriorated dramatically. We analyze loan quality as the performance of loans, adjusted for differences in borrower characteristics (such as credit score, level of indebtedness, ability to provide documentation), loan characteristics (such as product type, amortization term, loan amount, interest rate), and subsequent house price appreciation.
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 principal, the subprime-prime mortgage rate spread (subprime mark-up) should account for the default risk of subprime loans. For the rapid growth of the subprime mortgage market to have been sustainable, the increase in the overall riskiness of subprime loans should have been accompanied by an increase in the subprime mark-up. In this paper we show that this was not the case: Subprime markup—adjusted and not adjusted for changes in differences in borrower and loan characteristics—declined over time. With the benefit of hindsight we now know that indeed this situation was not sustainable, and the subprime mortgage market experienced a severe crisis in 2007. 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.22 Argentina in 1980, Chile in
22 A more detailed discussion, theory, and empirical evidence on such episodes is available in Dell'Ariccia and Marquez
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.
(2006), Demirgiic-Kunt and Detragiache (2002), Gourinchas, Valdes, and Landerretche (2001), and Kamisky and Reinhart (1999), among many others.
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