NBER WORKING PAPER SERIESAN EMPIRICAL MODEL OF SUBPRIME MORTGAGE DEFAULT FROM 2000TO 2007Patrick BajariSean ChuMinjung Park Working Paper 14625http://www.nber.org/papers/w14625NATIONAL BUREAU OF ECONOMIC RESEARCH1050 Massachusetts AvenueCambridge, MA 02138December 2008
We thank Narayana Kocherlakota, Andreas Lehnert, Monika Piazzesi, Tom Sargent, and Dick Todd
for helpful conversations. Bajari would like to thank the National Science Foundation for generous
research support. Thanks also go to Sean Flynn for helpful research assistance. The views expressed
herein are those of the author(s) and do not necessarily reflect the views of the National Bureau of
Economic Research.
© 2008 by Patrick Bajari, Sean Chu, and Minjung Park. All rights reserved. Short sections of text,not to exceed two paragraphs, may be quoted without explicit permission provided that full credit,
including © notice, is given to the source.
An Empirical Model of Subprime Mortgage Default from 2000 to 2007Patrick Bajari, Sean Chu, and Minjung Park NBER Working Paper No. 14625December 2008JEL No. G01,G18,G2,G33,R51
ABSTRACT
The turmoil that started with increased defaults in the subprime mortgage market has generated instabilityin the financial system around the world. To better understand the root causes of this financial instability,
we quantify the relative importance of various drivers behind subprime borrowers’ decision to default.In our econometric model, we allow borrowers to default either because doing so increases their lifetime
wealth or because of short-term budget constraints, treating the decision as the outcome of a bivariate
probit model with partial observability. We estimate our model using detailed loan-level data fromLoanPerformance and the Case-Shiller home price index. According to our results, one main driver
of default is the nationwide decrease in home prices. The decline in home prices caused many borrowers’
outstanding mortgage liability to exceed their home value, and for these borrowers default can increase
their wealth. Another important driver is deteriorating loan quality: The increase of borrowers with
poor credit and high payment to income ratios elevates default rates in the subprime market. We discuss
policy implications of our results. Our findings point to flaws in the securitization process that led
to the current wave of defaults. Also, we use our model to evaluate alternative policies aimed at reducing
the rate of default.Patrick BajariProfessor of EconomicsUniversity of Minnesota4-101 Hanson Hall1925 4th Street SouthMinneapolis, MN 55455and NBERbajari@econ.umn.eduSean ChuFederal Reserve Board of GovernorsSean.Chu@frb.govMinjung Park Department of EconomicsUniversity of Minnesota4-101 Hanson Hall1925 Fourth Street SouthMinneapolis, MN 55455mpark@umn.edu
1 Introduction
Subprime mortgages are made to borrowers who have a higher probability of default due to low creditquality or risk factors associated with the loan, such as a small downpayment. The subprime marketexperienced substantial growth starting in the mid- to late 1990s. The percentage of all mortgages thatwere subprime grew from less than 5% in 1994 to 20% in 2005.
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Much of this growth was made possibleby an expansion in the market for private-issue mortgage-backed securities (MBS). Securitization throughMBS and related credit derivatives made it less costly to originate and fund loans that did not conformto the underwriting standards of the government-sponsored enterprises (GSEs), Fannie Mae and FreddieMac, which are the chief securitizers of prime mortgages.Beginning in late 2006, the United States subprime mortgage market experienced a sharp increasein delinquencies and foreclosures. In the third quarter of 2005, 10.76% of all subprime mortgages weredelinquent and 3.31% were in the process of foreclosure. By comparison, the corresponding …gureswere 18.67% and 11.81% in the second quarter of 2008. The turmoil in the housing market has alsogenerated broader instability in …nancial markets. Because securitization transfers ownership of thestream of mortgage payments from the originator to noteholders—chie‡y other …nancial institutions—the capital structures of these other institutions became seriously impaired when the unexpected spikein default rates caused the value of MBS to plunge. Thus, not only have subprime lenders such as NewCentury Financial Corporation been forced to declare bankruptcy, but also commercial- and investmentbanks have experienced substantial losses from write-downs on the value of MBS and collateralized debtobligations. A further consequence has been the collapse of major institutions including Bear Stearnsand Lehman Brothers. The resulting reduction in economywide lending is linked to what many forecastcould be the worst recession since the Great Depression.Policymakers have initiated a number of responses to the rise in defaults and worsening conditionsin credit markets. The United States government has earmarked $700 billion to fund capital injectionsinto …nancial institutions, instituted a credit facility to swap MBS for treasury securities, and placed thepreviously independently operating Fannie Mae and Freddie Mac under conservatorship. The FederalReserve Board has announced a $600 billion program to purchase the direct debt of Fannie Mae andFreddie Mac as well as MBS issued by the two corporations, with the goal of lowering mortgage rates andincreasing the availability of credit for housing purchases. The Federal Deposit Insurance Corporation
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Source: Moody’s Economy.com.
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