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BPEA Article

Making Sense of the Subprime Crisis

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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.

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