Making Sense of the Subprime Crisis

Andreas Lehnert,

Andreas Lehnert Director - Federal Reserve Board

Kristopher Gerardi,

KG

Kristopher Gerardi Federal Reserve Bank of Atlanta

Paul Willen, and

Paul Willen Senior Economist and Policy Advisor - Federal Reserve Bank of Boston

Shane M. Sherlund

SMS

Shane M. Sherlund Board of Governors of the Federal Reserve System

Deborah Lucas and

Deborah Lucas Sloan Distinguished Professor of Finance - MIT Sloan School of Management, Director - MIT Golub Center for Finance and Policy

Nicholas S. Souleles

NSS

Nicholas S. Souleles

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.