We document the emergence of a disconnect between mortgage and Treasury interest rates in the summer of 2003. Following the end of the Federal Reserve expansionary cycle in June 2003, mortgage rates failed to rise according to their historical relationship with Treasury yields, leading to significantly and persistently easier mortgage credit conditions. We uncover this phenomenon by analyzing a large dataset with millions of loan-level observations, which allows us to control for the impact of varying loan, borrower and geographic characteristics. These detailed data also reveal that delinquency rates started to rise for loans originated after mid 2003, exactly when mortgage rates disconnected from Treasury yields and credit became relatively cheaper… This paper contributes to the literature documenting the shift in the supply of credit towards marginal borrowers during the US housing boom. What we add to this literature, through our focus on loan-level interest rates and their conditional spread over Treasuries, is a sharper identification of the timing of this discontinuity, and of some of the factors behind it. In terms of timing, we pin-point the emergence of the conundrum to July 2003, and highlight that a process of progressive credit quality deterioration started immediately after this date. In terms of factors, we relate the conundrum to the attempt of originators to sustain their level of activity by entering new markets, following the collapse of the refinancing business.
Alejandro Justiniano, Giorgio E. Primiceri, Andrea Tambalotti