Making Sense of the Subprime Crisis

Making Sense of the Subprime Crisis

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.

Krostopher Gerardi, Andreas Lehnert, Shane M Sherlund, and Paul Willen

Brookings Institution

Fall 2008

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