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com/abstract=1020396
Understanding the Subprime Mortgage Crisis
Yuliya Demyanyk, Otto Van Hemert

This Draft: December 5, 2008
First Draft: October 9, 2007
Abstract
Using loan-level data, we analyze the quality of subprime mortgage loans by adjusting their performance
for differences in borrower characteristics, loan characteristics, and macroeconomic conditions. We find
that the quality of loans deteriorated for six consecutive years before the crisis and that securitizers
were, to some extent, aware of it. We provide evidence that the rise and fall of the subprime mortgage
market follows a classic lending boom-bust scenario, in which unsustainable growth leads to the collapse
of the market. Problems could have been detected long before the crisis, but they were masked by high
house price appreciation between 2003 and 2005.

Demyanyk: Banking Supervision and Regulation, Federal Reserve Bank of St. Louis, P.O. Box 442, St. Louis, MO
63166, Yuliya.Demyanyk@stls.frb.org. Van Hemert: Department of Finance, Stern School of Business, New York University,
44 W. 4th Street, New York, NY 10012, ovanheme@stern.nyu.edu. The authors would like to thank Cliff Asness, Joost
Driessen, William Emmons, Emre Ergungor, Scott Frame, Xavier Gabaix, Dwight Jaffee, Ralph Koijen, Andreas Lehnert,
Andrew Leventis, Chris Mayer, Andrew Meyer, Toby Moskowitz, Lasse Pedersen, Robert Rasche, Matt Richardson, Stefano
Risa, Bent Sorensen, Matthew Spiegel, Stijn Van Nieuwerburgh, James Vickery, Jeff Wurgler, anonymous referees, and
seminar participants at the Federal Reserve Bank of St. Louis; the Florida Atlantic University; the International Monetary
Fund; the second New York Fed—Princeton liquidity conference; Lehman Brothers; the Baruch-Columbia-Stern real estate
conference; NYU Stern Research Day; Capula Investment Management; AQR Capital Management,; the Conference on the
Subprime Crisis and Economic Outlook in 2008 at Lehman Brothers; Freddie Mac; Federal Deposit and Insurance Corporation
(FDIC); U.S. Securities and Exchange Comission (SEC); Office of Federal Housing Enterprise Oversight (OFHEO); Board of
Governors of the Federal Reserve System; Carnegie Mellon University; Baruch; University of British Columbia, University of
Amsterdam; the 44th Annual Conference on Bank Structure and Competition at the Federal Reserve Bank of Chicago; the
Federal Reserve Research and Policy Activities; Sixth Colloquium on Derivatives, Risk-Return and Subprime, Lucca, Italy;
and the Federal Reserve Bank of Cleveland; The views expressed are those of the authors and do not necessarily reflect the
official positions of the Federal Reserve Bank of St. Louis or the Federal Reserve System.
Electronic copy available at: http://ssrn.com/abstract=1020396 Electronic copy available at: http://ssrn.com/abstract=1020396
1 Introduction
The subprime mortgage crisis of 2007 was characterized by an unusually large fraction of subprime mort-
gages originated in 2006 and 2007 becoming delinquent or in foreclosure only months later. The crisis
spurred massive media attention; many different explanations of the crisis have been proffered. The goal
of this paper is to answer the question: “What do the data tell us about the possible causes of the cri-
sis?” To this end we use a loan-level database containing information on about half of all U.S. subprime
mortgages originated between 2001 and 2007.
The relatively poor performance of vintage 2006 and 2007 loans is illustrated in Figure 1 (left panel).
At every mortgage loan age, loans originated in 2006 and 2007 show a much higher delinquency rate than
loans originated in earlier years at the same ages.
Figure 1: Actual and Adjusted Delinquency Rate
The figure shows the age pattern in the actual (left panel) and adjusted (right panel) delinquency rate for the different vintage years.
The delinquency rate is defined as the cumulative fraction of loans that were past due 60 or more days, in foreclosure, real-estate owned,
or defaulted, at or before a given age. The adjusted delinquency rate is obtained by adjusting the actual rate for year-by-year variation in
FICO scores, loan-to-value ratios, debt-to-income ratios, missing debt-to-income ratio dummies, cash-out refinancing dummies, owner-
occupation dummies, documentation levels, percentage of loans with prepayment penalties, mortgage rates, margins, composition of
mortgage contract types, origination amounts, MSA house price appreciation since origination, change in state unemployment rate since
origination, and neighborhood median income.
0
5
10
15
20
25
30
35
3 4 5 6 7 8 9 10 11 12 13 14 15 16 17
Loan Age (Months)
2007
2006
2005
2004
2003
2002
2001
Actual Delinquency Rate (%)
0
5
10
15
20
25
3 4 5 6 7 8 9 10 11 12 13 14 15 16 17
Loan Age (Months)
2007
2006
2005
2004
2003
2002
2001
Adjusted Delinquency Rate (%)
We document that the poor performance of the vintage 2006 and 2007 loans was not confined to a
particular segment of the subprime mortgage market. For example, fixed-rate, hybrid, purchase-money,
cash-out refinancing, low-documentation, and full-documentation loans originated in 2006 and 2007 all
1
Electronic copy available at: http://ssrn.com/abstract=1020396
showed substantially higher delinquency rates than loans made the prior five years. This contradicts a
widely held belief that the subprime mortgage crisis was mostly confined to hybrid or low-documentation
mortgages.
We explore to what extent the subprime mortgage crisis can be attributed to different loan charac-
teristics, borrower characteristics, macroeconomic conditions, and vintage (origination) year effects. The
most important macroeconomic factor is subsequent house price appreciation, measured as the MSA-level
house price change between the time of origination and the time of loan performance evaluation. For
the empirical analysis, we run a proportional odds duration model with the probability of (first-time)
delinquency a function of these factors and loan age.
We find that loan and borrower characteristics are very important in terms of explaining the cross-
section of loan performance. However, because these characteristics were not sufficiently different in 2006
and 2007 compared with the prior five years, they cannot explain the unusually weak performance of
vintage 2006 and 2007 loans. For example, a one-standard-deviation increase in the debt-to-income ratio
raises the likelihood (the odds ratio) of a current loan turning delinquent in a given month by as much as a
factor of 1.14. However, because the average debt-to-income ratio was just 0.2 standard deviations higher
in 2006 than its level in previous years, it contributes very little to the inferior performance of vintage
2006 loans. The only variable in the considered proportional odds model that contributed substantially
to the crisis is the low subsequent house price appreciation for vintage 2006 and 2007 loans, which can
explain about a factor of 1.24 and 1.39, respectively, higher-than-average likelihood for a current loan to
turn delinquent.
1
Due to geographical heterogeneity in house price changes, some areas have experienced
larger-than-average house price declines and therefore have a larger explained increase in delinquency and
foreclosure rates.
2
The coefficients of the vintage dummy variables, included as covariates in the proportional odds model,
measure the quality of loans, adjusted for differences in observed loan characteristics, borrower charac-
teristics, and macroeconomic circumstances. In Figure 1 (right panel) we plot the adjusted delinquency
rates, which are obtained by using the estimated coefficients for the vintage dummies and imposing the
requirement that the average actual and average adjusted delinquency rates are equal for any given age.
As shown in Figure 1 (right panel), the adjusted delinquency rates have been steadily rising for the
1
Other papers that research the relationship between house prices and mortgage financing include Genesove and Mayer
(1997), Genesove and Mayer (2001), and Brunnermeier and Julliard (2007).
2
Also, house price appreciation may differ in cities versus rural areas. See for example Glaeser and Gyourko (2005) and
Gyourko and Sinai (2006).
2
past seven years. In other words, loan quality—adjusted for observed characteristics and macroeconomic
circumstances—deteriorated monotonically between 2001 and 2007. Interestingly, 2001 was among the
worst vintage years in terms of actual delinquency rates, but is in fact the best vintage year in terms of
the adjusted rates. High interest rates, low average FICO credit scores, and low house price appreciation
created the “perfect storm” in 2001, resulting in a high actual delinquency rate; after adjusting for these
unfavorable circumstances, however, the adjusted delinquency rates are low.
In addition to the monotonic deterioration of loan quality, we show that over time the average combined
loan-to-value ratio increased, the fraction of low documentation loans increased, and the subprime-prime
rate spread decreased. The rapid rise and subsequent fall of the subprime mortgage market is therefore
reminiscent of a classic lending boom-bust scenario.
3
The origin of the subprime lending boom has often
been attributed to the increased demand for so-called private-label mortgage-backed securities (MBSs)
by both domestic and foreign investors. Our database does not allow us to directly test this hypothesis,
but an increase in demand for subprime MBSs is consistent with our finding of lower spreads and higher
volume. Mian and Sufi (2008) find evidence consistent with this view that increased demand for MBSs
spurred the lending boom.
The proportional odds model used to estimate the adjusted delinquency rates assumes that the co-
variate coefficients are constant over time. We test the validity of this assumption for all variables and
find that it is the most strongly rejected for the loan-to-value (LTV) ratio. High-LTV borrowers in 2006
and 2007 were riskier than those in 2001 in terms of the probability of delinquency, for given values of the
other explanatory variables. Were securitizers aware of the increasing riskiness of high-LTV borrowers?
4
To answer this question, we analyze the relationship between the mortgage rate and LTV ratio (along with
the other loan and borrower characteristics). We perform a cross-sectional ordinary least squares (OLS)
regression, with the mortgage rate as the dependent variable, for each quarter from 2001Q1 to 2007Q2 for
both fixed-rate mortgages and 2/28 hybrid mortgages. Figure 2 shows that the coefficient on the first-lien
LTV variable, scaled by the standard deviation of the first-lien LTV ratio, has been increasing over time.
We thus find evidence that securitizers were aware of the increasing riskiness of high-LTV borrowers, and
3
Berger and Udell (2004) discuss the empirical stylized fact that during a monetary expansion lending volume typically
increases and underwriting standards loosen. Loan performance is the worst for those loans underwritten toward the end
of the cycle. Demirg¨ u¸ c-Kunt and Detragiache (2002) and Gourinchas, Valdes, and Landerretche (2001) find that lending
booms raise the probability of a banking crisis. Dell’Ariccia and Marquez (2006) show in a theoretical model that a change
in information asymmetry across banks might cause a lending boom that features lower standards and lower profits. Ruckes
(2004) shows that low screening activity may lead to intense price competition and lower standards.
4
For loans that are securitized (as are all loans in our database), the securitizer effectively dictates the mortgage rate
charged by the originator.
3
adjusted mortgage rates accordingly.
Figure 2: Sensitivity of Mortgage Rate to First-Lien Loan-to-Value Ratio
The figure shows the effect of the first-lien loan-to-value ratio on the mortgage rate for first-lien fixed-rate and 2/28 hybrid mortgages.
The effect is measured as the regression coefficient on the first-lien loan-to-value ratio (scaled by the standard deviation) in an ordinary
least squares regression with the mortgage rate as the dependent variable and the FICO score, first-lien loan-to-value ratio, second-lien
loan-to-value ratio, debt-to-income ratio, missing debt-to-income ratio dummy, cash-out refinancing dummy, owner-occupation dummy,
prepayment penalty dummy, origination amount, term of the mortgage, prepayment term, and margin (only applicable to 2/28 hybrid)
as independent variables. Each point corresponds to a separate regression, with a minimum of 18,784 observations.
0
.1
.2
.3
.4
.5
S
c
a
l
e
d

R
e
g
r
e
s
s
i
o
n

C
o
e
f
f
i
c
i
e
n
t

(
%
)
2001 2002 2003 2004 2005 2006 2007
Year
FRM
2/28 Hybrid
We show that our main results are robust to analyzing mortgage contract types separately, focusing
on foreclosures rather than delinquencies, and specifying the empirical model in numerous different ways,
like allowing for interaction effects between different loan and borrower characteristics. The latter includes
taking into account risk-layering—the origination of loans that are risky in several dimensions, such as
the combination of a high LTV ratio and a low FICO score.
As an extension, we estimate our proportional odds model using data just through year-end 2005
and again obtain the continual deterioration of loan quality from 2001 onward. This means that the
seeds for the crisis were sown long before 2007, but detecting them was complicated by high house price
appreciation between 2003 and 2005—appreciation that masked the true riskiness of subprime mortgages.
In another extension, we find an increased probability of delinquency for loans originated in low- and
moderate-income areas, defined as areas with median income below 80 percent of the larger Metropolitan
Statistical Area median income. This points toward a negative by-product of the 1977 Community
Reinvestment Act and Government Sponsored Enterprises housing goals, which seek to stimulate loan
4
origination in low- and moderate-income areas.
There is a large literature on the determinants of mortgage delinquencies and foreclosures, dating
back to at least Von Furstenberg and Green (1974). Recent contributions include Cutts and Van Order
(2005) and Pennington-Cross and Chomsisengphet (2007).
5
Other papers analyzing the subprime crisis
include Gerardi, Shapiro, and Willen (2008), Mian and Sufi (2008), DellAriccia, Igan, and Laeven (2008),
and Keys, Mukherjee, Seru, and Vig (2008). Our paper makes several novel contributions. First, we
quantify how much different determinants have contributed to the observed high delinquency rates for
vintage 2006 and 2007 loans, which led up to the 2007 subprime mortgage crisis. Our data enables us
to show that the effect of different loan-level characteristics as well as low house price appreciation was
quantitatively too small to explain the poor performance of 2006 and 2007 vintage loans. Second, we
uncover a downward trend in loan quality, determined as loan performance adjusted for differences in
loan and borrower characteristics and macroeconomic circumstances. We further show that there was a
deterioration of lending standards and a decrease in the subprime-prime mortgage rate spread during the
2001–2007 period. Together these results provide evidence that the rise and fall of the subprime mortgage
market follows a classic lending boom-bust scenario, in which unsustainable growth leads to the collapse
of the market. Third, we show that the continual deterioration of loan quality could have been detected
long before the crisis by means of a simple statistical exercise. Fourth, securitizers were, to some extent,
aware of this deterioration over time, as evidenced by changing determinants of mortgage rates. Fifth,
we detect an increased likelihood of delinquency in low- and middle-income areas, after controlling for
differences in neighborhood incomes and other loan, borrower, and macroeconomic factors. This empirical
finding seems to suggest that the housing goals of the Community Reinvestment Act and/or Government
Sponsored Enterprises—those intended to increase lending in low- and middle-income areas—might have
created a negative by-product, that is associated with higher loan delinquencies.
The structure of this paper is as follows. In Section 2 we show the descriptive statistics for the subprime
mortgages in our database. In Section 3 we discuss the empirical strategy we employ. In Section 4 we
present the baseline-case results and in Section 5 we discuss extensions and robustness checks. In Section
6 we demonstrate the increasing riskiness of high-LTV borrowers, and the extent to which securitizers
were aware of this risk. In Section 7 we analyze the subprime-prime rate spread and in Section 8 we
conclude. We provide several additional robustness checks in the appendices.
5
Deng, Quigley, and Van Order (2000) discuss the simultaneity of the mortgage prepayment and default option. Campbell
and Cocco (2003) and Van Hemert (2007) discuss mortgage choice over the life cycle.
5
2 Descriptive Analysis
In this paper we use the First American CoreLogic LoanPerformance (henceforth: LoanPerformance)
database, as of June 2008, which includes loan-level data on about 85 percent of all securitized subprime
mortgages; (more than half of the U.S. subprime mortgage market).
6
There is no consensus on the exact definition of a subprime mortgage loan. The term subprime can be
used to describe certain characteristics of the borrower (e.g., a FICO credit score less than 620),
7
lender
(e.g., specialization in high-cost loans),
8
security of which the loan can become a part (e.g., high projected
default rate for the pool of underlying loans), or mortgage contract type (e.g., no money down and no
documentation provided, or a 2/28 hybrid). The common element across definitions of a subprime loan
is a high default risk. In this paper, subprime loans are those underlying subprime securities. We do not
include less risky Alt-A mortgage loans in our analysis. We focus on first-lien loans and consider the 2001
through 2008 sample period.
9
We first outline the main characteristics of the loans in our database at origination. Second, we discuss
the delinquency rates of these loans for various segments of the subprime mortgage market.
2.1 Loan Characteristics at Origination
Table 1 provides the descriptive statistics for the subprime mortgage loans in our database that were
originated between 2001 and 2007. In the first block of Table 1 we see that the annual number of
originated loans increased by a factor of four between 2001 and 2006 and the average loan size almost
doubled over those five years. The total dollar amount originated in 2001 was $57 billion, while in 2006 it
was $375 billion. In 2007, in the wake of the subprime mortgage crisis, the dollar amount originated fell
sharply to $69 billion, and was primarily originated in the first half of 2007.
In the second block of Table 1, we split the pool of mortgages into four main mortgage contract types.
6
Mortgage Market Statistical Annual (2007) reports securitization shares of subprime mortgages each year from 2001 to
2006 equal to 54, 63, 61, 76, 76, and 75 percent respectively.
7
The Board of Governors of the Federal Reserve System, The Office of the Controller of the Currency,
the Federal Deposit Insurance Corporation, and the Office of Thrift Supervision use this definition. See e.g.
http://www.fdic.gov/news/news/press/2001/pr0901a.html
8
The U.S. Department of Housing and Urban Development uses HMDA data and interviews lenders to identify subprime
lenders among them. There are, however, some subprime lenders making prime loans and some prime lenders originating
subprime loans.
9
Since the first version of this paper in October 2007, LoanPerformance has responded to the request by trustees’ clients
to reclassify some of its subprime loans to Alt-A status. While it is not clear to us whether the pre- or post-reclassification
subprime data are the most appropriate for research purposes, we checked that our results are robust to the reclassification.
In this version we focus on the post-classification data.
6
Table 1: Loan Characteristics at Origination for Different Vintages
Descriptive statistics for the first-lien subprime loans in the LoanPerformance database.
2001 2002 2003 2004 2005 2006 2007
Size
Number of Loans (*1000) 452 737 1, 258 1, 911 2, 274 1, 772 316
Average Loan Size (*$1000) 126 145 164 180 200 212 220
Mortgage Type
FRM (%) 33.2 29.0 33.6 23.8 18.6 19.9 27.5
ARM (%) 0.4 0.4 0.3 0.3 0.4 0.4 0.2
Hybrid (%) 59.9 68.2 65.3 75.8 76.8 54.5 43.8
Balloon (%) 6.5 2.5 0.8 0.2 4.2 25.2 28.5
Loan Purpose
Purchase (%) 29.7 29.3 30.1 35.8 41.3 42.4 29.6
Refinancing (cash out) (%) 58.4 57.4 57.7 56.5 52.4 51.4 59.0
Refinancing (no cash out) (%) 11.2 12.9 11.8 7.7 6.3 6.2 11.4
Variable Means
FICO Score 601.2 608.9 618.1 618.3 620.9 618.1 613.2
Combined Loan-to-Value Ratio (%) 79.4 80.1 82.0 83.6 84.9 85.9 82.8
Debt-to-Income Ratio (%) 38.0 38.5 38.9 39.4 40.2 41.1 41.4
Missing Debt-to-Income Ratio Dummy (%) 34.7 37.5 29.3 26.5 31.2 19.7 30.9
Investor Dummy (%) 8.2 8.1 8.1 8.3 8.3 8.2 8.2
Documentation Dummy (%) 76.5 70.4 67.8 66.4 63.4 62.3 66.7
Prepayment Penalty Dummy (%) 75.9 75.3 74.0 73.1 72.5 71.0 70.2
Mortgage Rate (%) 9.7 8.7 7.7 7.3 7.5 8.4 8.6
Margin for ARM and Hybrid Mortgage Loans (%) 6.4 6.6 6.3 6.1 5.9 6.1 6.0
7
Most numerous are the hybrid mortgages, accounting for more than half of all subprime loans in our
data set originated between 2001 and 2007. A hybrid mortgage carries a fixed rate for an initial period
(typically 2 or 3 years) and then the rate resets to a reference rate (often the 6-month LIBOR) plus a
margin. The fixed-rate mortgage contract became less popular in the subprime market over time and
accounted for just 20 percent of the total number of loans in 2006. In contrast, in the prime mortgage
market, most mortgage loans were of the fixed-rate type during this period.
10
In 2007, as the subprime
mortgage crisis hit, the popularity of FRMs rose to 28 percent. The proportion of balloon mortgage
contracts jumped substantially in 2006, and accounted for 25 percent of the total number of mortgages
originated that year. A balloon mortgage does not fully amortize over the term of the loan and therefore
requires a large final (balloon) payment. Less than 1 percent of the mortgages originated over the sample
period were adjustable-rate (non-hybrid) mortgages.
In the third block of Table 1, we report the purpose of the mortgage loans. In about 30 to 40 percent
of cases, the purpose was to finance the purchase of a house. Approximately 55 percent of our subprime
mortgage loans were originated to extract cash, by refinancing an existing mortgage loan into a larger new
mortgage loan. The share of loans originated in order to refinance with no cash extraction was relatively
small.
In the final block of Table 1, we report the mean values for the loan and borrower characteristics that
we will use in the statistical analysis (see Table 2 for a definition of these variables). The average FICO
credit score rose 20 points between 2001 and 2005. The combined loan-to-value (CLTV) ratio, which
measures the value of all-lien loans divided by the value of the house, slightly increased over 2001–2006,
primarily because of the increased popularity of second-lien and third-lien loans. The (back-end) debt-
to-income ratio (if provided) and the fraction of loans with a prepayment penalty were fairly constant.
For about a third of the loans in our database, no debt-to-income ratio was provided (the reported value
in those cases is zero); this is captured by the missing debt-to-income ratio dummy variable. The share
of loans with full documentation fell considerably over the sample period, from 77 percent in 2001 to 67
percent in 2007. The mean mortgage rate fell from 2001 to 2004 and rebounded after that, consistent
with movements in both the 1-year and 10-year Treasury yields over the same period. Finally, the margin
(over a reference rate) for adjustable-rate and hybrid mortgages stayed rather constant over time.
10
For example Koijen, Van Hemert, and Van Nieuwerburgh (2007) show that the fraction of conventional, single-family,
fully amortizing, purchase-money loans reported by the Federal Housing Financing Board in its Monthly Interest Rate Survey
that are of the fixed-rate type fluctuated between 60 and 90 percent from 2001 to 2006. Vickery (2007) shows that empirical
mortgage choice is affected by the eligibility of the mortgage loan to be purchased by Fannie Mae and Freddie Mac.
8
We do not report summary statistics on the loan source, such as whether a mortgage broker interme-
diated, as the broad classification used in the database rendered this variable less informative.
2.2 Performance of Loans by Market Segments
We define a loan to be delinquent if payments on the loan are 60 or more days late, or the loan is reported
as in foreclosure, real estate owned, or in default. We denote the ratio of the number of vintage k loans
experiencing a first-time delinquency at age s over the number of vintage k loans with no first-time
delinquency for age < s by
˜
P
k
s
. We compute the actual (cumulative) delinquency rate for vintage k at
age t as the fraction of loans experiencing a delinquency at or before age t
Actual
k
t
= 1 −
t
¸
s=1

1 −
˜
P
k
s

(1)
We define the average actual delinquency rate as
Actual
t
= 1 −
t
¸
s=1

1 −
¯
P
s

, where (2)
¯
P
s
=
1
7
2007
¸
i=2001
˜
P
k
s
(3)
In Figure 1 (left panel) we show that for the subprime mortgage market as a whole, vintage 2006 and
2007 loans stand out in terms of high delinquency rates. In Figure 3, we again plot the age pattern in
the delinquency rate for vintages 2001 through 2007 and split the subprime mortgage market into various
segments. As the figure shows, the poor performance of the 2006 and 2007 vintages is not confined to a
particular segment of the subprime market, but rather reflects a (subprime) market-wide phenomenon.
In the six panels of Figure 3 we see that for hybrid, fixed-rate, purchase-money, cash-out refinancing,
low-documentation, and full-documentation mortgage loans, the 2006 and 2007 vintages show the highest
delinquency rate pattern. In general, vintage 2001 loans come next in terms of high delinquency rates,
and vintage 2003 loans have the lowest delinquency rates. Notice that the scale of the vertical axis differs
across the panels. The delinquency rates for the fixed-rate mortgages (FRMs) are lower than those for
hybrid mortgages but exhibit a remarkably similar pattern across vintage years.
In Figure 4 we plot the delinquency rates of all outstanding mortgages. Notice that the fraction of
FRMs that are delinquent remained fairly constant from 2005Q1 to 2007Q2. Delinquency rates in this
9
Figure 3: Actual Delinquency Rate for Segments of the Subprime Mortgage Market
The figure shows the age pattern in the delinquency rate for different segments. The delinquency rate is defined as the cumulative
fraction of loans that were past due 60 or more days, in foreclosure, real-estate owned, or defaulted, at or before a given age.
0
5
10
15
20
25
30
35
3 4 5 6 7 8 9 10 11 12 13 14 15 16 17
Loan Age (Months)
2007
2006
2005
2004
2003
2002
2001
Hybrid Mortgage Loans
0
5
10
15
20
25
3 4 5 6 7 8 9 10 11 12 13 14 15 16 17
Loan Age (Months)
2007
2006
2005
2004
2003
2002
2001
Fixed−Rate Mortgage Loans
0
5
10
15
20
25
30
35
40
3 4 5 6 7 8 9 10 11 12 13 14 15 16 17
Loan Age (Months)
2007
2006
2005
2004
2003
2002
2001
Purchase−Money Mortgage Loans
0
5
10
15
20
25
30
3 4 5 6 7 8 9 10 11 12 13 14 15 16 17
Loan Age (Months)
2007
2006
2005
2004
2003
2002
2001
Cash−Out Refinancing Mortgage Loans
0
5
10
15
20
25
30
3 4 5 6 7 8 9 10 11 12 13 14 15 16 17
Loan Age (Months)
2007
2006
2005
2004
2003
2002
2001
Full−Documentation Mortgage Loans
0
5
10
15
20
25
30
35
40
3 4 5 6 7 8 9 10 11 12 13 14 15 16 17
Loan Age (Months)
2007
2006
2005
2004
2003
2002
2001
Low−or−No−Doc Mortgage Loans
10
figure are defined as the fraction of loans delinquent at any given time, not cumulative. These rates are
consistent with those used in an August 2007 speech by the Chairman of the Federal Reserve System
(Bernanke (2007)), who said “For subprime mortgages with fixed rather than variable rates, for example,
serious delinquencies have been fairly stable.” It is important, though, to realize that this result is driven
by an aging effect of the FRM pool, caused by a decrease in the popularity of FRMs from 2001 to 2006
(see Table 1). In other words, FRMs originated in 2006 in fact performed unusually poorly (Figure 3,
upper-right panel), but if one plots the delinquency rate of outstanding FRMs over time (Figure 4, left
panel), the weaker performance of vintage 2006 loans is masked by the aging of the overall FRM pool.
Figure 4: Actual Delinquency Rates of Outstanding Mortgages
The Figure shows the actual delinquency rates of all outstanding FRMs and hybrids from January 2000 through June 2008.
0
5
10
15
20
25
30
35
40
2000 2001 2002 2003 2004 2005 2006 2007 2008
Year
FRM
Hybrid
Actual Delinquency Rate (%)
3 Statistical Model Specification
The focus of our paper is on the performance of subprime mortgage loans in the first 17 months after
origination, for which we already have data for the vintages of particular interest: 2006 and 2007. Given
this focus on young loans, we include delinquency—the earliest stage of payment problems—in our non-
performance measure. Delinquency is an intermediate stage for a loan in trouble; the loan may eventually
cure or terminate with a prepayment or default.
Our paper is related to the vast literature on empirical mortgage termination. Termination occurs
either through a prepayment or a default. An analysis of mortgage termination lends itself naturally to
11
duration (i.e., survival) models, with prepayment and default as competing reasons for termination. Im-
portant contributions to this literature include Deng (1997), Ambrose and Capone (2000), Deng, Quigley,
and Van Order (2000), Calhoun and Deng (2002), Pennington-Cross (2003), Deng, Pavlov, and Yang
(2005), Clapp, Deng, and An (2006), and Pennington-Cross and Chomsisengphet (2007).
We apply the duration model methodology to the intermediate status of delinquency by defining non-
survival as “having ever been 60 days delinquent or worse,” which includes formerly delinquent loans that
are prepaid or cured. Transition from survival to non-survival will occur when a loan becomes 60 or more
days delinquent or defaults for the first time. As a robustness check, we used “being currently 60 or more
days delinquent or in default” as the non-performance measure, ran a standard logit regression, and found
qualitatively similar results for the effect of explanatory variables and the effect of vintage year dummies
(unreported results).
3.1 Empirical Model Specification
We are interested in the number of months (duration) until a loan becomes at least 60 days delinquent
or defaults for the first time. Denoting this time by T, we define the probability that at age t loan i
with covariate values x
i,t
becomes delinquent for the first time, conditional on not having been delinquent
before, as
P
i,t
= Pr {T = t|T ≥ t, x
i,t
} (4)
Because the monthly choice whether to make a mortgage payment is discrete, we use a proportional
odds model, the discrete-time analogue to the popular proportional hazard model:
log

P
i,t
1 − P
i,t

= α
t
+ β

x
i,t
(5)
where α
t
is an age-dependent constant and β is a vector of coefficients. The name “proportional odds”
arises from the fact that the vector of coefficients, β, does not have an age subscript and thus the log odds
are proportional to the covariate values at any age.
3.2 Estimation
The proportional odds model, Equation 5, is typically estimated for the full panel at once using either
partial likelihood (see Cox (1972)) or maximum likelihood methodologies. The small sample properties for
12
these two estimation methods are potentially different, but for a sample size of 10, 000 loans the methods
already provide very similar estimates for β. For larger sample sizes the computational burden of the
partial likelihood function quickly becomes unmanageable. This is a result of heavily tied data in our
discrete time setup, where the term “tied” refers to loans experiencing first-time delinquency at the exact
same age. We therefore estimate the proportional odds model using maximum likelihood, which has the
added advantage that it provides estimates of the loan age effect, α
t
. We use a random sample of 1 million
loans for this exercise.
We use the PROC LOGISTIC procedure in SAS for the maximum likelihood estimation. This method
is able to handle both left censoring (loans entering the sample at a later age) and right censoring (loans
leaving the sample prematurely, not due to a prepayment or default), using the non-informative censoring
assumption.
11
In order to generate unbiased delinquency rate plots (as in Figure 1, right panel), we
classify prepaid loans as non-delinquent and non-censored, because we know for sure that they will never
experience a first-time delinquency.
Because we include vintage year dummies as covariates we have to restrict the maximum age considered
in our analysis to 17 months, the latest age for which we have an observation for the 2007 origination
year; the maximum likelihood estimation requires each covariate, including the vintage 2007 dummy, have
some dispersion in the covariate values for each age.
12
For the adjusted delinquency rate plots viewed at
the end of 2005 and 2006 (Figure 5), we restrict the analysis to a maximum age of 11 months.
3.3 Reported Output
The AgeEffect statistic is defined as the proportional odds ratio for first-time delinquency at a particular
age t for the average (over the full sample) vector of covariate values at age t, ¯ x
t
:
AgeEffect
t
= exp (α
t
+ β

¯ x
t
) (6)
The Marginal statistic is defined as the log proportional odds ratio associated with a one standard
11
Loans securitized several months after origination are not observed in our data between the origination date and the
securitization date; therefore, they are left censored. In addition, if the securitizer goes out of business we stop observing
their loans and therefore they are right censored.
12
For more information on this, see page 126 of Allison (2007).
13
deviation increase in variable j, σ
j
:
Marginal
j
= β
j
σ
j
= log

exp (α
t
+ β

x
i,t
+ β
j
σ
j
)
exp (α
t
+ β

x
i,t
)

(7)
The advantage of taking the log in Equation 7 is that the effect of an increase of σ
j
in covariate j is minus
the effect of a decrease of σ
j
, and thus the absolute effect is invariant to the chosen direction of change.
The Deviation statistic measures the difference between the mean value of a variable in a particular
vintage year and the mean value of that variable measured over the entire sample, expressed in the number
of standard deviations of the variable. For example, for vintage 2001 and variable j it is the difference
between the mean value for variable j in 2001, x01
j
, and the mean value over all vintages, ¯ x
j
, expressed
in the number of standard deviations:
Deviation
j
=
x01
j
− ¯ x
j
σ
j
(8)
The Contribution statistic measures the deviation of the (average) log proportional odds of first-time
delinquency in a particular vintage year from the (average) log proportional odds of first-time delinquency
over the entire sample that can be explained by a particular variable. For example for vintage 2001 and
variable j we have:
Contribution
j
= β
j

x01
j
− ¯ x
j

= log

exp

α
t
+ β

x
i,t
+ β
j

x01
j
− ¯ x
j

exp (α
t
+ β

x
i,t
)

(9)
= Marginal
j
∗ Deviation
j
As a straightforward generalization of Equation 9, the combined contribution of two variables is simply
the sum of the individual contributions. This property will be used for reporting the total contribution
of all covariates in Table 3.
The probability of experiencing a first-time delinquency at or before age = t is given by
Pr {T ≤ t|x
t
, x
t−1
, ..} = 1 −
t
¸
s=1
(1 − P
s
) (10)
To visualize the magnitude of the vintage year effect, we evaluate the above expression for the value of
14
P
s
that satisfies
log

P
s
1 − P
s

= log

¯
P
s
1 −
¯
P
s

+ D
k

¯
D (11)
where D
k
is the estimated coefficient for for the vintage year k dummy variable and
¯
D is the average
estimated vintage dummy variable. This expression uses the proportional odds property for explana-
tory variables, including vintage year dummies, illustrated in Equation 5. Combining Equations 10 and
Equation 11 we obtain the adjusted delinquency rate for vintage year k at age t
Adjusted
k
t
= 1 −
t
¸
s=1
1
1 +

¯
P
s
1−
¯
P
s

exp
¸
D
k

¯
D
¸
(12)
Notice that for an average vintage year, D
k
=
¯
D, Equation 12 simplifies to
Adjusted
t
= 1 −
t
¸
s=1

1 −
¯
P
s

= Actual
t
(13)
4 Empirical Results for the Baseline-Case Specification
In this section we investigate to what extent the proportional odds model model can explain the high levels
of delinquencies for the vintage 2006 and 2007 mortgage loans in our database. All results in this section
are based on a random sample of one million first-lien subprime mortgage loans, originated between 2001
and 2007.
4.1 Variable Definitions
Table 2 provides the definitions of the variables (covariates) included in the baseline-case specification of
the proportional odds model.
The borrower and loan characteristics we use in the analysis are: the FICO credit score; the combined
loan-to-value ratio; the value of the debt-to-income ratio (when provided); a dummy variable indicating
whether the debt-to-income ratio was missing (reported as zero); a dummy variable indicating whether the
loan was a cash-out refinancing; a dummy variable indicating whether the borrower was an investor (as
opposed to an owner-occupier); a dummy variable indicating whether full documentation was provided; a
dummy variable indicating whether there is a prepayment penalty on a loan; the (initial) mortgage rate;
15
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16
and the margin for adjustable-rate and hybrid loans.
13
In addition, we use three macro variables in the baseline-case specification. First, we construct a
variable that measures house price appreciation from the time of origination until the time we evaluate
whether a loan is delinquent. To this end we use metropolitan statistical area (MSA) level house price
indexes from the Office of Federal Housing Enterprise Oversight (OFHEO) and match loans with MSAs
by using the zip code provided by LoanPerformance.
14
Second, we include the state-level change in the
unemployment rate from the time of loan origination until the time of performance evaluation, reported by
the Bureau of Economic Analysis. An increase in the state unemployment rate increases the probability
a homeowner lost his or her job, which increases the probability of financial problems. Third, we use a
measure for the quality of the neighborhood: zip-code-level median household income in 1999. The data
are from U.S. Census Bureau 2000 and are collected every 10 years. The better the neighborhood the
more motivated a borrower may be to stay current on a mortgage. In Table 2 we report the expected sign
for the regression coefficient on each of the explanatory variables in parentheses.
4.2 Determinants of Delinquency
In Tables 3, 4 and 5 we present the determinants of delinquency using the proportional odds methodology.
The tables report the output of a single estimation; due to limited page size, the output is spread over
three separate tables. The first column of Table 3 lists the covariates included (other than the vintage and
age dummies which are reported in Tables 4 and 5). Column two documents the marginal effect of the
covariates (Equation 7). All marginal effects have the expected sign, as shown in Table 2. Except for the
hybrid and ARM dummies, all variables are statistically significant at the 1% level. The four explanatory
variables with the largest (absolute) marginal effects and thus the most important for explaining cross-
sectional differences in loan performance, are the FICO score, the combined loan-to-value ratio, the
mortgage rate, and house price appreciation. According to the estimates, for example, a one standard
deviation increase in the FICO score decreases the log odds of first-time delinquency by 47.94 percent;
or, equivalently, changes the odds by a factor exp(−0.4794) = 0.6192. The product type has a relatively
small effect on the performance of a loan, beyond what is explained by other characteristics. In Figure
13
We also studied specifications that included loan purpose, reported in Table 1, and housing outlook, defined as the house
price accumulation in the year prior to the loan origination. These variables were not significant and did not materially
change the regression coefficients on the other variables.
14
Estimating house price appreciation on the MSA-level, as opposed to the individual property level introduces a potential
measurement error of this variable. To the best of our knowledge, there is no data available to estimate the size of this
measurement error or to evaluate its impact on the results.
17
3 we show that FRMs experience a much lower delinquency rate than hybrid mortgages, which therefore
must be driven by borrowers with better characteristics selecting into FRMs.
15
The contributions of each covariate to explaining different delinquency rates for each vintage year are
given in columns 3 through 9 of Table 3. The very high delinquency rate for vintage 2001 loans can
be explained in large part by a near perfect storm of unfavorable lending and economic conditions: low
FICO scores, high mortgage rates, relatively low house price appreciation, and low (negative) change in
unemployment, all contributing to a higher probability of delinquency. In total, the different covariates
contributed to a 51.71 percent increase in the log odds of delinquency, compared to a situation with average
covariate values. This is slightly higher than the 45.06 percent for vintage 2006 and slightly smaller than
the 56.09 percent for vintage 2007—years for which low house price appreciation and high mortgage rates
increased the probability of delinquency. For vintage years 2003 and 2005, high house price appreciation
contributed to a reduced probability of delinquency compared to a situation with average covariate values.
Therefore, we can say that high house price appreciation between 2003 and 2005 masked the true riskiness
of subprime mortgages for these vintage years.
16
By construction, the weighted-average contribution of a variable over 2001–2007 is zero, with weights
equal to the number of originated loans in a particular vintage year. Because the number of loans
originated differs across vintages years, the equal-weighted average contribution is not zero, hence rows
for the contribution variable in Table 3 do not add up to zero.
As shown in Table 4, the coefficients of the vintage dummy variables increase every year, which demon-
strates that loan quality deteriorated after adjusting for the other covariates included in the specification.
This deterioration is illustrated by the adjusted delinquency rates depicted in Figure 1 (right panel), which
is computed using Equation 12. This picture is in sharp contrast with that obtained from actual rates,
where 2003 was the year with the lowest delinquency rates, and 2001 was the year with the third-highest
rates (see Figure 1, left panel). We test whether the differences between every subsequent vintage year
dummy coefficients are statistically significant. We find that the yearly change (increase) in the dummy
variables are statistically significant at the 1% confidence level, except for the small increase from 2006
to 2007. The vintage dummy coefficients reported in Table 4 are in the same units as the contribution of
the different variables presented in Table 3. For example, comparing vintages 2001 and 2007, the total
15
Consistent with this finding, LaCour-Little (2007) shows that individual credit characteristics are important for mortgage
product choice.
16
Shiller (2007) argues that house prices were too high compared to fundamentals in this period and refers to the house
price boom as a classic speculative bubble largely driven by an extravagant expectation for future house price appreciation.
18
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19
Table 4: Determinants of Delinquency, Vintage Dummy Variables
The table shows the output of the proportional odds duration model. The first column reports the vintage dummies included. The
values for the other covariates are outlined in Tables 3 and 5. The second column shows the estimated coefficients. The vintage 2001
dummy was not included as covariate; hence the coefficients on the other covariates are relative to the 2001 vintage and we report a
zero value for the coefficient of 2001. A “∗” indicates statistical significance at the 1% level.
Explanatory Variable Estimate, %
Vintage 2001 0.00
Vintage 2002 5.12

Vintage 2003 23.64

Vintage 2004 49.71

Vintage 2005 57.93

Vintage 2006 64.65

Vintage 2007 66.69

Table 5: Determinants of Delinquency, Age Dummy Variables
The table shows the output of the proportional odds duration model. Each column reports the corresponding odds ratio, AgeEffect,
estimated for each age dummy variable based on Equation 6. The values for the other covariates are reported in Tables 3 and 4.
Age, Months 3 4 5 6 7 8 9 10
AgeEffect (*100) 0.04 0.31 0.55 0.67 0.72 0.72 0.73 0.72
Age, Months 11 12 13 14 15 16 17 –
AgeEffect (*100) 0.73 0.72 0.73 0.71 0.70 0.69 0.67 –
20
contribution of the (non-vintage dummy) covariates increased by 4.38 percent (from 51.71 percent to
56.09 percent). This pales in comparison to the 66.69 percent increase in the vintage dummy variable
over 2001–2007.
To illustrate the effect of age on the conditional probability of first-time delinquency, in Table 5 we
report the odds statistic defined in Equation 6. We see that the odds of first-time delinquency peaks
around age of 7–13 months.
Next we study the following question: Based on information available at the end of 2005, was the
dramatic deterioration of loan quality since 2001 already apparent? Notice that we cannot answer this
question by simply inspecting vintages 2001 through 2005 in Figure 1 (right panel), because the com-
putation of the adjusted delinquency rate for, say, vintage 2001 loans, makes use of a regression model
estimated using data from 2001 through 2008. Hence, we re-estimate the proportional odds model under-
lying Figure 1 (right panel) making use of only 2001–2005 data. The resulting age pattern in adjusted
delinquency rates is plotted in Figure 5 (left panel). We again obtain the result that the adjusted delin-
quency rate rose monotonically from 2001 onward. We therefore conclude that the dramatic deterioration
of loan quality in this decade should have been apparent by the end of 2005. Figure 5 (right panel) depicts
the situation when we use data available at the end of 2006. Again, the deterioration is clearly visible.
17
The finding of a continual decline in loan quality also occurs when analyzing foreclosure rates (Ap-
pendix A), and analyzing hybrid mortgages and FRMs separately (Appendix B). Moreover, the main
result documenting the monotonic rise in adjusted delinquency rates is found based on numerous alterna-
tive model specifications discussed in Section 5.
5 Empirical Results for Alternative Specifications
In this Section we explore various alternative model specifications.
5.1 Different Loan and Borrower Characteristics
We explore numerous alternative loan and borrower characteristics as covariates for robustness. First, we
consider as covariates those of the baseline case presented in Table 3, plus the 10 interaction and quadratic
terms that can be constructed from the four most important variables: the FICO score, the CLTV ratio,
17
One reason why investors did not massively start to avoid or short subprime-related securities is that the timing of the
subprime market downturn may have been hard to predict. Moreover, a short position is associated with a high cost of carry
(Feldstein (2007)).
21
Figure 5: Adjusted Delinquency Rate, Viewed at the End of 2005 and 2006
The figure shows the adjusted delinquency rate using data available at the end of 2005 (left panel) and 2006 (right panel). The
delinquency rate is defined as the cumulative fraction of loans that were past due 60 or more days, in foreclosure, real-estate owned, or
defaulted, at or before a given age. The adjusted delinquency rate is obtained by adjusting the actual rate for year-by-year variation in
FICO scores, loan-to-value ratios, debt-to-income ratios, missing debt-to-income ratio dummies, cash-out refinancing dummies, owner-
occupation dummies, documentation levels, percentage of loans with prepayment penalties, mortgage rates, margins, composition of
mortgage contract types, origination amounts, MSA house price appreciation since origination, change in state unemployment rate since
origination, and neighborhood median income.
0
2
4
6
8
10
12
14
16
3 4 5 6 7 8 9 10 11
Loan Age (Months)
2005
2004
2003
2002
2001
Adjusted Delinquency Rate (%), End of 2005
0
2
4
6
8
10
12
14
16
3 4 5 6 7 8 9 10 11
Loan Age (Months)
2006
2005
2004
2003
2002
2001
Adjusted Delinquency Rate (%), End of 2006
22
the mortgage rate, and subsequent house price appreciation. Allowing for these additional terms, we take
into account the effect of risk-layering—such as, for example, the effect of a combination of a borrower’s
low FICO score and a high CLTV ratio—on the probability of delinquency. It is in this case not a priori
clear what the sign on the FICO-CLTV interaction variable should be. A negative sign would mean that
a low FICO and a high CLTV reinforce each other and give rise to a predicted delinquency probability
that is higher than that without interaction effect. A positive sign could be explained by lenders who
originate a low FICO and high CLTV loan only if they have positive private information on the loan or
borrower quality. We find that the coefficient on the FICO-CLTV interaction term is close to zero and
insignificant.
More certain is the sign we expect on the HPA-CLTV variable. Low house price appreciation is
expected to especially give rise to a higher delinquency probability for a high CLTV ratio, because the
borrower is closer to a situation with negative equity in the house (combined value of the mortgage loans
larger than the market value of the house). Consistent with this intuition, we find a negative and significant
(at the 1% level) coefficient on this interaction term. The vintage dummy variables are still increasing
every year. Inclusion of the 10 interaction covariates does not substantially increase the overall fit of the
model, as measured by the log likelihood ratio.
Second, we included a dummy for the presence of a second-lien loan. We find that the coefficient
is positive and statistically significant and that it inherits some of the statistical power of the CLTV
variable. The coefficients of the other covariates are virtually unchanged. Inclusion of the dummy does
not substantially increase the overall fit of the model, as measured by the log likelihood ratio.
Third, we considered as an additional covariate a dummy variable taking the value one whenever
the CLTV equals 80 percent. With this variable, we are aiming to control for silent seconds, referring
to a situation where an investor takes out a second-lien loan not reported in our database typically
in combination with an 80 percent first-lien loan. This dummy variable is statistically significant but
economically not very large and moreover hardly improved the overall fit.
Fourth, we excluded the loans where the debt-to-income ratio is missing from the sample to make sure
the measurement error associated with this variable does not lead to a significant bias in the results. The
estimates based on the smaller subsample, in which the debt-to-income variable has non-zero reported
values, are statistically and economically similar to those based on the entire sample of loans.
Fifth, we performed several robustness checks regarding the reset rate for hybrid mortgages. The
23
initial mortgage rate for hybrid mortgages is potentially lower during the initial fixed-rate period. For
99.57 percent of mortgages in our database, the duration of the initial fixed rate period is 24 months or
more; the most common fixed period is 24 months, followed by 36 months. Since we focus on delinquency
in the first 17 months, we expect the initial mortgage rate to be an important covariate. However, because
households may have factored in the rise in the mortgage rate before the actual reset date, we include the
post-reset margin as an additional covariate in the baseline case specification. The margin is in excess of
a reference rate, which in 99.34 percent of the cases is the 6-month LIBOR rate. As a robustness check
we performed the analysis for FRMs and Hybrid mortgages separately, with FRMs not being subject to
resets, and in both cases obtain our main result that adjusted delinquency rates rose monotonically over
2001–2007 (see Figure 9).
We performed two additional robustness checks. First, instead of the margin we included a covariate
defined as the margin plus the 6-month LIBOR interest rate at origination (obtained from Bloomberg).
Second, instead of the margin we included a covariate defined as the margin plus the 6-month LIBOR
interest rate at origination minus the initial mortgage rate. This captures the potential change in interest
rate at the time of reset, based on the 6-month LIBOR rate at origination. For FRMs the values of the
new covariates are set to zero. The marginal effect for the two new covariates is 12.27 percent and 7.83
percent respectively; the marginal effects for the margin covariates in the baseline case are 11.84 percent,
as reported in Table 3. Among the other covariates, only the coefficient for the initial rate is slightly
affected. The marginal effect of the initial rate is 29.58 percent and 33.60 percent for the two alternative
specifications respectively, compared to a marginal effect of 29.21 percent in the baseline case, as reported
in Table 3. The log likelihood of the different specifications is virtually identical.
5.2 Local house-by-house return volatility
In this section we study local house-by-house return volatility as as additional covariate. We obtained the
data from the Office of Federal Housing Enterprise Oversight (OFHEO) at the state level.
18
OFHEO uses
a repeated-sales methodology to compute house price appreciation in a geographical unit (like a state or
MSA) and, as a by-product, obtains an estimate of the variation of the return around the mean in the
geographical unit.
19
18
We would like to thank OFHEO for providing us with the data. MSA-level data exist but was not available for public
release.
19
For more details on this procedure, see the official OFHEO documentation by Calhoun (1996). Also De Jong, Driessen,
and Van Hemert (2008) explain the interpretation and computation of the volatility parameters.
24
The house-by-house volatility is 8.05 percent, annualized and averaged over the full panel (50 states plus
the District of Columbia in the 2001Q1-2008Q2 sample period). Most of the variation of the volatility is
in the cross-section: the standard deviation of the volatility estimate across states (averaged over 2001Q1-
2008Q2) is 0.75 percent. The standard deviation of the volatility estimate over time (averaged over the
50 states plus the District of Columbia) is only 0.18 percent.
Ambrose, LaCour-Little, and Huszar (2005) use the volatility estimate of OFHEO to compute the
probability of negative equity. In the special case that the equity in the house is exactly zero, based on
house price appreciation in the geographical area, there is a 50 percent probability the household actually
has negative equity based on the (unobserved) house price appreciation of the individual house, assuming
a symmetric (e.g., normal) distribution for the house-by-house deviation from the MSA mean. When the
equity is positive based on house price appreciation in the geographical area, the higher the house-by-house
return volatility, the higher the probability an individual house has negative equity. When the equity is
negative, the situation is reversed.
While it is not just the probability of having negative equity for an individual house that matters,
but in general the whole probability distribution, it does seem intuitive that the effect of local house-by-
house return volatility may interact with HPA. Hence, in the empirical implementation we add both the
house-by-house return volatility by itself and the interaction of this volatility with HPA as covariates.
Consistent with Ambrose, LaCour-Little, and Huszar (2005), the estimated coefficient on the interaction
term is positive; when house price appreciation is high in the geographical area, high volatility increases
the probability of having negative equity for a specific house. The effect is statistically significant at
the 1% level, but has a small Chi-squared statistic compared to the baseline case covariates and has a
negligible impact on the coefficients of the other covariates.
5.3 CRA and GSE Housing Goals
In this section we explore additional covariates related to the Community Reinvestment Act (CRA) and
Government Sponsored Enterprises (GSEs) housing goals. The 1977 Community Reinvestment Act (CRA)
is a United States federal law designed to encourage commercial banks and savings associations to meet
the needs of borrowers in all segments of their communities, including low- and moderate-income (LMI)
households and neighborhoods. The CRA does not list specific criteria for evaluating the performance
of financial institutions, but indicates that the evaluation process should accommodate the situation and
25
context of each individual institution. An institution’s CRA compliance record is, for example, taken
into account when applying for deposit facilities.
20
LMI neighborhoods have a median income level
that is less than 80 percent of the median income of a broader geographic area, e.g., the MSA for urban
neighborhoods.
21
With a similar objective of helping poor and underserved individuals and neighborhoods,
the Congress in 1992 established an affordable housing mission for Fannie Mae and Freddie Mac by
directing the Department of Housing and Urban Developement (HUD) to create specific mortgage purchase
goals for these Government Sponsored Enterprises (GSEs). The goals are primarily defined in terms of (i)
household income relative to median MSA income (for urban neighborhoods), (ii) neighborhood median
income relative to MSA median income, and (iii) minority concentration in the neighborhood.
22
To isolate the effect of CRA and the GSE housing goals from pure neighborhood effects, we study
the effect of LMI neighborhood status on the probability of delinquency, controlling for the baseline-
specification covariates, including the neighborhood median income.
We either include an LMI dummy that equals one if the median neighborhood income is less than 80
percent of the MSA median income, or we add the MSA median income. We use zip-code level median
household income and median MSA household income from the U.S. Census Bureau to compute the LMI
dummy.
23
The LMI dummy or MSA median income level pick up the difference in the probability of delinquency
for loans in MSAs with different median incomes, but in neighborhoods with the same median income and
with the same loan and borrower characteristics, giving rise to different incentives for CRA-complying
institutions and the GSEs. We interpret any effect from the LMI dummy or MSA median income to come
from the CRA and GSE housing goals, and thus assume that there is no direct effect of LMI status or
MSA median income on borrower behavior after controlling for neighborhood median income.
The results are presented in Table 6. Specification I corresponds to the baseline case of Table 3 and
is included as a benchmark. Of the baseline case covariates, we only report the neighborhood income to
preserve space. In specification II we add the MSA median income to the baseline case covariates. A higher
20
See http://www.federalreserve.gov/dcca/cra/
21
See Laderman (2004) for a further discussion.
22
See http://www.huduser.org/Datasets/GSE/gse2006.pdf Table 1 for the specific goals for 2000-2006.
23
The precise identification of CRA and GSE targeted neighborhoods is not feasible in our analysis for several reasons: (i)
the location of subprime lenders is not reported in the LoanPerformance data, thus we cannot identify the CRA targeted
community; and (ii) most frequently, CRA and GSE targeted communities are defined using census tract-level measures (such
as income, poverty level, and minority concentration). LoanPerformance data identifies each property location in zip codes,
which do not directly match with census tracts. Therefore, in our analysis we identify neighborhoods that can potentially
fall under CRA and GSE housing goals using either the LMI dummy variable or MSA-level median household income.
26
MSA median income increases the possibility a loan was made to advance CRA or GSE housing goals.
The positive and statistically significant (at the 1% level) marginal effect reported in the table effect thus
implies that CRA and GSE housing goal eligibility is associated with a higher probability of delinquency,
ceteris paribus. In specification III we add the LMI dummy to the baseline case covariates. We find a
positive and significant marginal effect, again implying that CRA and GSE housing goal eligibility raises
the probability of delinquency. Finally in specification IV we interact the LMI dummy with vintage
dummies to see how the LMI effect changed over time. For all vintage years the marginal effect is positive
and statistically significant at the 1% level, except for 2003, which is positive and statistically significant
at the 5% level. There is no clear trend over time.
Table 6: Low- and Moderate-Income Neighborhood Effect
This table reports marginal effects for different measures of neighborhood (median household) income relative to MSA (median household)
income. In all four specifications we include the baseline case variables used in Table 3, of which we only report neighborhood income
to preserve space. Specification I is the baseline case with no variable capturing the neighborhood income relative to the MSA income.
Specification II includes MSA income. Specification III includes a dummy with value one if neighborhood income is less than 80 percent
of MSA income; i.e., if it is a low- and moderate-income (LMI) neighborhood. Specification IV includes interaction variables of the
LMI dummy with vintage year dummies. The marginal effect for the interaction terms is computed as the product of the estimated
coefficient and the full sample standard deviations of LMI. A “∗” indicates statistical significance at the 1% level.
I II III IV
Neighborhood Income −8.81%* −9.10%∗ −6.95%∗ −6.94%∗
MSA Income − 1.07%∗ − −
LMI Dummy − − 2.82%∗ −
LMI 2001 − − − 6.26%∗
LMI 2002 − − − 4.52%∗
LMI 2003 − − − 1.75%
LMI 2004 − − − 3.64%∗
LMI 2005 − − − 2.67%∗
LMI 2006 − − − 1.79%∗
LMI 2007 − − − 3.79%∗
27
6 Non-Stationarity of the Loan-to-Value Effect
The proportional odds model used in Section 4 assumes that the covariate coefficients are constant over
time. That is, the effect of a unit change in a given covariate on the probability of first-time delinquency
is the same in, for example, 2006, as it is in 2001, holding constant the values of the other covariates. We
test the validity of this assumption for all variables in our analysis and find that the strongest rejection of a
constant coefficient is for the CLTV ratio. In this section we first discuss this finding and then turn to the
question of whether lenders were aware of the non-stationarity of the loan-to-value effect, by investigating
the relationship between the loan-to-value ratio and mortgage rates over time.
We estimate the proportional odds model with CLTV interacted with the seven vintage dummy vari-
ables, instead of just CLTV without interaction, as we have in the baseline case specification (Section 4).
We compute the marginal effect for a particular loan vintage as the product of the estimated coefficient
for the associated interaction variable and the standard deviation of CLTV for all vintages together, which
totals 0.10, 0.11, 0.14, 0.15, 0.22, 0.35, 0.34 for years 2001 to 2007, respectively. All seven coefficients are
highly statistically significant at the 1% level. Hence, the CLTV is an increasingly important determinant
of delinquency over time.
We examine whether lenders were aware that high LTV ratios were increasingly associated with riskier
borrowers. The combined LTV ratio rather than the first-lien LTV ratio is believed to be the main
determinant of delinquency because it is the burden of all the debt together that may trigger financial
problems for the borrower. In contrast, the first-lien LTV is the more important determinant of the
mortgage rate on a first-lien mortgage, because it captures the dollar amount at stake for the first-
lien lender.
24
For this reason, we test whether the sensitivity of the lender’s interest rate to the first-
lien LTV ratio changed over time. We perform a cross-sectional OLS regression with the mortgage
rate as the dependent variable, and loan characteristics, including the first-lien LTV and second-lien
LTV (CLTV minus first-lien LTV), as independent variables.
25
We perform one such regression for
each calendar quarter in our sample period. We can only expect to get accurate results when using
relatively homogeneous groups of loans, and therefore consider fully amortizing FRM and 2/28 hybrid
loans separately. Together these two contract types account for more than half of all mortgage loans in
24
This is confirmed by our empirical results. To conserve space the results are not reported.
25
Specifically, we use the FICO score, first-lien loan-to-value ratio, second-lien loan-to-value ratio, debt-to-income ratio, a
dummy for a missing debt-to-income ratio, a cash-out refinancing dummy, a dummy for owner occupation, documentation
dummy, prepayment penalty dummy, margin, origination amount, term of the mortgage, and prepayment term as the right-
hand-side variables.
28
our database. Each cross-sectional regression is based on a minimum of 18,784 observations.
Figure 2 shows the regression coefficient on the first-lien LTV ratio for each quarter from 2001Q1
through 2007Q2.
26
We scaled the coefficients by the standard deviation of the first-lien LTV ratio, and
they can therefore be interpreted as the changes in the mortgage rates when the first-lien LTV ratios are
increased by one standard deviation. In the fourth quarter of 2006, a one-standard-deviation increase in the
first-lien LTV ratio corresponded to about a 30-basis-point increase in the mortgage rate for 2/28 hybrids
and about a 40-basis-point increase for FRMs, keeping constant other loan characteristics. In contrast,
in the first quarter of 2001, the corresponding rate increase was 10 and 16 basis points, respectively.
This provides evidence that lenders were to some extent aware of high LTV ratios being increasingly
associated with risky borrowers.
27
In Appendix C we show that this result is robust to allowing for a
non-linear relationship between the mortgage rate and the first-lien LTV ratio. Finally, notice that the
effect of a one-standard-deviation increase in the first-lien LTV ratio on the 2/28 mortgage rate increased
substantially in the wake of the subprime mortgage crisis: from 30 basis points in 2007Q1 to 42 basis
points in 2007Q2.
7 Subprime-Prime Rate Spread
In general, interest rates on subprime mortgages are higher than on prime mortgages to compensate the
lender for the (additional) default risk associated with subprime loans. In this section we analyze the
time series of the subprime-prime rate spread, both with and without adjustment for changes in loan
and borrower characteristics. We focus on FRMs for this exercise. For hybrid mortgages the subprime-
prime comparison is more complicated because (i) both the initial (teaser) rate and the margin should be
factored in, and (ii) we don’t have good data on the prime initial rates and margins.
In Figure 6 we show the actual subprime-prime rate spread, defined in Equation (15) below. The
subprime rate for this exercise is calculated as the average across individual loans initial mortgage rate
for each calendar month (the data source is LoanPerformance); the prime rate is the contract rate on
FRMs reported by the Federal Housing Finance Board (FHFB) in its Monthly Interest Rate Survey.
28
The subprime-prime spread—the difference between the average subprime and prime rates—decreased
26
Our data extends to 2007Q3, but due to a near shutdown of the securitized subprime mortgage market we lack statistical
power in this quarter.
27
The effects of other loan characteristics on mortgage rates have been much more stable over time, as unreported results
suggest.
28
Available at http://www.fhfb.gov/GetFile.aspx?FileID=6416.
29
substantially over time, with the largest decline between 2001 and 2004, which coincides with the most
rapid growth in the number of loans originated (see Table 1). In Figure 6 we also plot the yield spread
between 10-year BBB and AAA corporate bonds, which we obtained from Standard and Poor’s Global
Fixed Income Research. Compared to the corporate BBB-AAA yield spread, the actual subprime-prime
rate spread declined much more and more steadily, hence the decline cannot just be attributed to a change
in the overall level of risk aversion.
Figure 6: FRM Rate Spread and Corporate Bond Yield Spread
The figure shows the FRM subprime-prime rate spread and the yield spread between 10-year BBB and AAA corporate bonds.
0
.5
1
1.5
2
2.5
3
3.5
2001 2002 2003 2004 2005 2006 2007
Year
Subprime−Prime Spread (%)
BBB−AAA Spread (%)
We perform a cross-sectional OLS regression with the loan-level spread as the dependent variable and
the prime rate and various subprime loan and borrower characteristics as the explanatory variables, using
data from 2001 through 2006.
29
spread
it
= β
0
+ β
1
prime
t
+ β

2
characteristics
it
+ error
it
, (14)
spread
it
= subprime
it
− prime
t
(15)
Notice that the β
1
prime
t
term corrects for the fact that the spread is affected by the prime rate itself,
and thus changes over the business cycle, because a higher prime rate increases the default probability
29
The explanatory factors in the regression are the FICO credit score, a dummy variable that equals one if full docu-
mentation was provided, a dummy variable that equals one if prepayment penalty is present, origination amount, value of
debt-to-income ratio, a dummy variable that equals one if debt-to-income was not provided, a dummy variable that equals
one if loan is a refinancing, a dummy variable that equals one if a borrower is an investor, loan-to-value ratio based on a
first-lien, and loan-to-value ratios based on a second, third, etc. liens if applicable.
30
on subprime loans for a given spread. In Figure 7 we plot the prediction error, averaged per origination
month t, along with a fitted linear trend.
Figure 7: Prediction Error in the Subprime-Prime Rate Spread
The figure shows the prediction error in the subprime-prime rate spread, determined in a regression of the spread on the prime rate
and the following loan and borrower characteristics: the FICO credit score, a dummy variable that equals one if full documentation
was provided, a dummy variable that equals one if a prepayment penalty is present, origination amount, value of debt-to-income ratio,
a dummy variable that equals one if debt-to-income was not provided, a dummy variable that equals one if the loan is a refinancing,
a dummy variable that equals one if a borrower is an investor, the loan-to-value ratio based on a first lien, and the loan-to-value ratio
based on a second, third, etc. liens if applicable.
−.5
−.25
0
.25
.5
.75
2001 2002 2003 2004 2005 2006 2007
Year
Prediction Error (%)
Fitted Trend
The downward trend in Figure 7 indicates that the subprime-prime spread, after adjusting for differ-
ences in observed loan and borrower characteristics, declined between 2001 to 2007. In Figure 1 (right
panel) we showed that loan quality, obtained by adjusting loan performance for differences in loan and
borrower characteristics and subsequent house price appreciation, deteriorated over the period, and thus
the (adjusted) riskiness of loans rose. Therefore, on a per-unit-of-risk basis, the subprime-prime mortgage
spread decreased even more than the level of the spread.
8 Concluding Remarks
The subprime mortgage market experienced explosive growth between 2001 and 2006. Angell and Rowley
(2006) and Kiff and Mills (2007), among others, argue that this was facilitated by the development of
so-called private-label mortgage backed securities (they do not carry any kind of credit risk protection by
the Government Sponsored Enterprises). Investors in search of higher yields kept increasing their demand
31
for private-label mortgage-backed securities, which also led to sharp increases in the subprime share of
the mortgage market (from around 8 percent in 2001 to 20 percent in 2006) and in the securitized share
of the subprime mortgage market (from 54 percent in 2001 to 75 percent in 2006).
In this paper we show that during the dramatic growth of the subprime (securitized) mortgage market,
the quality of the market deteriorated dramatically. We measure loan quality as the performance of loans,
adjusted for differences in borrower characteristics (such as the credit score, a level of indebtedness, an
ability to provide documentation), loan characteristics (such as a product type, an amortization term, a
loan amount, an mortgage interest rate), and macroeconomic conditions (such as house price appreciation,
level of neighborhood income and change in unemployment).
The decline in loan quality was monotonic, but not equally spread among different types of borrowers.
Over time, high-LTV borrowers became increasingly risky (their adjusted performance worsened more)
compared to low-LTV borrowers. Securitizers seem to have been aware of this particular pattern in the
relative riskiness of borrowers: We show that over time mortgage rates became more sensitive to the LTV
ratio of borrowers. In 2001, for example, a borrower with a one standard deviation above-average LTV
ratio paid a 10 basis point premium compared to an average LTV borrower. By 2006, in contrast, the
premium paid by the high LTV borrower was around 30 basis points.
In principal, the subprime-prime mortgage rate spread (subprime mark-up) should account for the
default risk of subprime loans. For the rapid growth of the subprime mortgage market to have been
sustainable, the increase in the overall riskiness of subprime loans should have been accompanied by an
increase in the subprime mark-up. In this paper we show that this was not the case: The subprime mark-
up—adjusted and not adjusted for changes in differences in borrower and loan characteristics—declined
over time. With the benefit of hindsight we now know that indeed this situation was not sustainable,
and the subprime mortgage market crashed in 2007. In many respects, the subprime market experienced
a classic lending boom-bust scenario with rapid market growth, loosening underwriting standards, dete-
riorating loan performance, and decreasing risk premiums.
30
Argentina in 1980, Chile in 1982, Sweden,
Norway, and Finland in 1992, Mexico in 1994, Thailand, Indonesia, and Korea in 1997 all experienced the
culmination of a boom-bust scenario, albeit in different economic settings.
Were problems in the subprime mortgage market apparent before the actual crisis erupted in 2007?
30
A more detailed discussion, theory, and empirical evidence on such episodes is available in Dell’Ariccia and Marquez
(2006), Demirg¨ u¸ c-Kunt and Detragiache (2002), Gourinchas, Valdes, and Landerretche (2001), and Kamisky and Reinhart
(1999), among many others.
32
Our answer is yes, at least by the end of 2005. Using the data available only at the end of 2005, we
show that the monotonic degradation of the subprime market was already apparent. Loan quality had
been worsening for five years in a row at that point. Rapid appreciation in housing prices masked the
deterioration in the subprime mortgage market and thus the true riskiness of subprime mortgage loans.
When housing prices stopped climbing, the risk in the market became apparent.
33
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36
A Foreclosure Rates
In this Appendix we show the continual deterioration of adjusted loan performance using foreclosure, instead of delinquency,
as a measure of loan performance. Foreclosure is defined as a loan being in foreclosure, real-estate owned, or in default. In
Figure 8 we present actual (left panel) and adjusted (right panel) foreclosure rates. The actual foreclosure rate for loans age
six months and younger is close to zero, in contrast to the actual delinquency rate at this age (presented in Figure 1 (left
panel)). For older aged loans the actual foreclosure rate is roughly speaking twice as low as the actual delinquency rate.
Similar to the actual delinquency rates (Figure 1 (left panel), the actual foreclosure rates (Figure 8, left panel) are highest
for 2007, 2006, and 2001 and lowest for 2003 and 2004.
Using foreclosure instead of delinquency as a measure for non-performance, the adjusted foreclosure rates every vintage
year starting in2002, as can be seen from Figure 8, right panel. The adjusted foreclosure rates of vintage 2001 loans are
between vintages 2002 and 2003. The change for each year is statistically significant at the 1% confidence level.
Figure 8: Actual and Adjusted Foreclosure Rates
The figure shows the age pattern in the actual (left panel) and adjusted (right panel) foreclosure rate for the different vintage years. The
foreclosure rate is defined as the cumulative fraction of loans that were in foreclosure, real-estate owned, or defaulted, at or before a given
age. The adjusted foreclosure rate is obtained by adjusting the actual rate for year-by-year variation in FICO scores, loan-to-value ratios,
debt-to-income ratios, missing debt-to-income ratio dummies, cash-out refinancing dummies, owner-occupation dummies, documentation
levels, percentage of loans with prepayment penalties, mortgage rates, margins, composition of mortgage contract types, origination
amounts, MSA house price appreciation since origination, change in state unemployment rate since origination, and neighborhood
median income.
0
2
4
6
8
10
12
14
16
18
3 4 5 6 7 8 9 10 11 12 13 14 15 16 17
Loan Age (Months)
2007
2006
2005
2004
2003
2002
2001
Actual Foreclosure Rate (%)
0
2
4
6
8
10
3 4 5 6 7 8 9 10 11 12 13 14 15 16 17
Loan Age (Months)
2007
2006
2005
2004
2003
2002
2001
Adjusted Foreclosure Rate (%)
B Adjusted Delinquency Rate for Hybrids and FRMs Separately
In this Appendix we show that the continual deterioration of adjusted loan performance over the 2001–2007 period also
occurs when estimating a separate proportional odds model for the main contract types, as opposed to the baseline case in
the main text where we perform a single estimation for all loans together, but include contract type dummies in the regression
37
specification. Figure 9 shows the adjusted delinquency rate for the two main contract types: 2/28 hybrids and FRMs. For
both contract types, the adjusted delinquency rates have increased monotonically over time. Except for a level difference,
the age pattern for the different vintage years looks very much the same for the two contract types.
Figure 9: Adjusted Delinquency Rates for Hybrids and FRMs Separately
The figure shows the adjusted delinquency rates based on hybrid mortgages (left panel) and FRMs (right panel) separately. The
delinquency rate is defined as the cumulative fraction of loans that were past due 60 or more days, in foreclosure, real-estate owned, or
defaulted, at or before a given age. The adjusted delinquency rate is obtained by adjusting the actual rate for year-by-year variation in
FICO scores, loan-to-value ratios, debt-to-income ratios, missing debt-to-income ratio dummies, cash-out refinancing dummies, owner-
occupation dummies, documentation levels, percentage of loans with prepayment penalties, mortgage rates, margins, composition of
mortgage contract types, origination amounts, MSA house price appreciation since origination, change in state unemployment rate since
origination, and neighborhood median income.
0
5
10
15
20
25
30
3 4 5 6 7 8 9 10 11 12 13 14 15 16 17
Loan Age (Months)
2007
2006
2005
2004
2003
2002
2001
Hybrid Mortgage Loans
0
5
10
15
20
3 4 5 6 7 8 9 10 11 12 13 14 15 16 17
Loan Age (Months)
2007
2006
2005
2004
2003
2002
2001
Fixed−Rate Mortgage Loans
C Non-Linearity in the Sensitivity of the Mortgage Rate to the LTV
In Figure 2 we plotted the sensitivity of the fixed-rate and 2/28 hybrid mortgage rates to the first-lien LTV ratio. The
sensitivity is defined as the regression coefficient on the first-lien LTV (scaled by the standard deviation) in a regression
with the mortgage rate as dependent variable and the first-lien LTV, the second-lien LTV, and the other loan and borrower
characteristics listed in Section 6, as independent variables.
In this appendix we study the robustness of this result to adding the square of the first-lien LTV and the square of the
second-lien LTV as independent variables, therefore allowing for a non-linear functional form. In Figure 10 we report the
resulting scaled marginal effect of the first-lien LTV for fixed-rate and 2/28 hybrid mortgages evaluated at a first-lien LTV
of 80 percent (left panel) and 90 percent (right panel). Without non-linear terms the marginal effect is simply given by
the regression coefficient. This is what we plotted in Figure 2. With the quadratic terms, the marginal effect is given by
β
LTV
+ 2β
LTV
2X, where the βs are the regression coefficients and X is the first-lien LTV ratio at which the marginal effect
is evaluated.
38
Figure 10: Sensitivity of Mortgage Rate to First-Lien LTV Ratio Allowing for Non-Linearity
The figure shows the scaled marginal effect of the first-lien loan-to-value (LTV) ratio on the mortgage rate for first-lien fixed-rate and
2/28 hybrid mortgages, evaluated at a first-lien LTV of 80 percent (left panel) and 90 percent (right panel). The effect is determined using
an OLS regression with the interest rate as dependent variable and the FICO score, first-lien LTV (and the square), second-lien LTV
(and the square), debt-to-income ratio, missing debt-to-income ratio dummy, cash-out refinancing dummy, owner-occupation dummy,
prepayment penalty dummy, origination amount, term of the mortgage, prepayment term, and margin as independent variables.
0
.2
.4
.6
.8
2001 2002 2003 2004 2005 2006 2007
Year
FRM
2/28 Hybrid
Scaled Marginal Effect of First−Lien LTV = 80% (%)
0
.2
.4
.6
.8
1
1.2
2001 2002 2003 2004 2005 2006 2007
Year
FRM
2/28 Hybrid
Scaled Marginal Effect of First−Lien LTV = 90% (%)
As shown in Figure 10, the marginal effect is rising over time, consistent with the baseline case results presented in Figure
2. Moreover, we find that there is a statistically and economically significant non-linear effect of the first-lien LTV on the
mortgage rate. Comparing the left and right panels in Figure 10, the higher the first-lien LTV ratio, the more sensitive is the
mortgage rate to changes in the first-lien LTV. The largest difference between the results based on specifications with and
without non-linearity is observed for 2/28 hybrid mortgages in 2007 at a first-lien LTV of 90 percent (right panel). The scaled
marginal effect increases by 27 basis points over the course of 3 months in 2007 when the model allows for non-linearity. In
contrast, in the case without non-linearity, as in Figure 2, the increase in the scaled marginal effect is only 13 basis points.
39

1

Introduction

The subprime mortgage crisis of 2007 was characterized by an unusually large fraction of subprime mortgages originated in 2006 and 2007 becoming delinquent or in foreclosure only months later. The crisis spurred massive media attention; many different explanations of the crisis have been proffered. The goal of this paper is to answer the question: “What do the data tell us about the possible causes of the crisis?” To this end we use a loan-level database containing information on about half of all U.S. subprime mortgages originated between 2001 and 2007. The relatively poor performance of vintage 2006 and 2007 loans is illustrated in Figure 1 (left panel). At every mortgage loan age, loans originated in 2006 and 2007 show a much higher delinquency rate than loans originated in earlier years at the same ages. Figure 1: Actual and Adjusted Delinquency Rate
The figure shows the age pattern in the actual (left panel) and adjusted (right panel) delinquency rate for the different vintage years. The delinquency rate is defined as the cumulative fraction of loans that were past due 60 or more days, in foreclosure, real-estate owned, or defaulted, at or before a given age. The adjusted delinquency rate is obtained by adjusting the actual rate for year-by-year variation in FICO scores, loan-to-value ratios, debt-to-income ratios, missing debt-to-income ratio dummies, cash-out refinancing dummies, owneroccupation dummies, documentation levels, percentage of loans with prepayment penalties, mortgage rates, margins, composition of mortgage contract types, origination amounts, MSA house price appreciation since origination, change in state unemployment rate since origination, and neighborhood median income.

Actual Delinquency Rate (%) 35 30 25 20 15 10 5 0 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 Loan Age (Months) 5 0 3 4 5
2007 2006 2005 2004 2003 2002 2001

Adjusted Delinquency Rate (%) 25 20 15 10
2007 2006 2005 2004 2003 2002 2001

6

7

8 9 10 11 12 13 14 15 16 17 Loan Age (Months)

We document that the poor performance of the vintage 2006 and 2007 loans was not confined to a particular segment of the subprime mortgage market. For example, fixed-rate, hybrid, purchase-money, cash-out refinancing, low-documentation, and full-documentation loans originated in 2006 and 2007 all

1

Electronic copy available at: http://ssrn.com/abstract=1020396

showed substantially higher delinquency rates than loans made the prior five years. This contradicts a widely held belief that the subprime mortgage crisis was mostly confined to hybrid or low-documentation mortgages. We explore to what extent the subprime mortgage crisis can be attributed to different loan characteristics, borrower characteristics, macroeconomic conditions, and vintage (origination) year effects. The most important macroeconomic factor is subsequent house price appreciation, measured as the MSA-level house price change between the time of origination and the time of loan performance evaluation. For the empirical analysis, we run a proportional odds duration model with the probability of (first-time) delinquency a function of these factors and loan age. We find that loan and borrower characteristics are very important in terms of explaining the crosssection of loan performance. However, because these characteristics were not sufficiently different in 2006 and 2007 compared with the prior five years, they cannot explain the unusually weak performance of vintage 2006 and 2007 loans. For example, a one-standard-deviation increase in the debt-to-income ratio raises the likelihood (the odds ratio) of a current loan turning delinquent in a given month by as much as a factor of 1.14. However, because the average debt-to-income ratio was just 0.2 standard deviations higher in 2006 than its level in previous years, it contributes very little to the inferior performance of vintage 2006 loans. The only variable in the considered proportional odds model that contributed substantially to the crisis is the low subsequent house price appreciation for vintage 2006 and 2007 loans, which can explain about a factor of 1.24 and 1.39, respectively, higher-than-average likelihood for a current loan to turn delinquent.1 Due to geographical heterogeneity in house price changes, some areas have experienced larger-than-average house price declines and therefore have a larger explained increase in delinquency and foreclosure rates.2 The coefficients of the vintage dummy variables, included as covariates in the proportional odds model, measure the quality of loans, adjusted for differences in observed loan characteristics, borrower characteristics, and macroeconomic circumstances. In Figure 1 (right panel) we plot the adjusted delinquency rates, which are obtained by using the estimated coefficients for the vintage dummies and imposing the requirement that the average actual and average adjusted delinquency rates are equal for any given age. As shown in Figure 1 (right panel), the adjusted delinquency rates have been steadily rising for the
Other papers that research the relationship between house prices and mortgage financing include Genesove and Mayer (1997), Genesove and Mayer (2001), and Brunnermeier and Julliard (2007). 2 Also, house price appreciation may differ in cities versus rural areas. See for example Glaeser and Gyourko (2005) and Gyourko and Sinai (2006).
1

2

Electronic copy available at: http://ssrn.com/abstract=1020396

past seven years. In other words, loan quality—adjusted for observed characteristics and macroeconomic circumstances—deteriorated monotonically between 2001 and 2007. Interestingly, 2001 was among the worst vintage years in terms of actual delinquency rates, but is in fact the best vintage year in terms of the adjusted rates. High interest rates, low average FICO credit scores, and low house price appreciation created the “perfect storm” in 2001, resulting in a high actual delinquency rate; after adjusting for these unfavorable circumstances, however, the adjusted delinquency rates are low. In addition to the monotonic deterioration of loan quality, we show that over time the average combined loan-to-value ratio increased, the fraction of low documentation loans increased, and the subprime-prime rate spread decreased. The rapid rise and subsequent fall of the subprime mortgage market is therefore reminiscent of a classic lending boom-bust scenario.3 The origin of the subprime lending boom has often been attributed to the increased demand for so-called private-label mortgage-backed securities (MBSs) by both domestic and foreign investors. Our database does not allow us to directly test this hypothesis, but an increase in demand for subprime MBSs is consistent with our finding of lower spreads and higher volume. Mian and Sufi (2008) find evidence consistent with this view that increased demand for MBSs spurred the lending boom. The proportional odds model used to estimate the adjusted delinquency rates assumes that the covariate coefficients are constant over time. We test the validity of this assumption for all variables and find that it is the most strongly rejected for the loan-to-value (LTV) ratio. High-LTV borrowers in 2006 and 2007 were riskier than those in 2001 in terms of the probability of delinquency, for given values of the other explanatory variables. Were securitizers aware of the increasing riskiness of high-LTV borrowers?4 To answer this question, we analyze the relationship between the mortgage rate and LTV ratio (along with the other loan and borrower characteristics). We perform a cross-sectional ordinary least squares (OLS) regression, with the mortgage rate as the dependent variable, for each quarter from 2001Q1 to 2007Q2 for both fixed-rate mortgages and 2/28 hybrid mortgages. Figure 2 shows that the coefficient on the first-lien LTV variable, scaled by the standard deviation of the first-lien LTV ratio, has been increasing over time. We thus find evidence that securitizers were aware of the increasing riskiness of high-LTV borrowers, and
Berger and Udell (2004) discuss the empirical stylized fact that during a monetary expansion lending volume typically increases and underwriting standards loosen. Loan performance is the worst for those loans underwritten toward the end of the cycle. Demirg¨c-Kunt and Detragiache (2002) and Gourinchas, Valdes, and Landerretche (2001) find that lending u¸ booms raise the probability of a banking crisis. Dell’Ariccia and Marquez (2006) show in a theoretical model that a change in information asymmetry across banks might cause a lending boom that features lower standards and lower profits. Ruckes (2004) shows that low screening activity may lead to intense price competition and lower standards. 4 For loans that are securitized (as are all loans in our database), the securitizer effectively dictates the mortgage rate charged by the originator.
3

3

origination amount. focusing on foreclosures rather than delinquencies.784 observations. Scaled Regression Coefficient (%) . In another extension.and moderate-income areas. This means that the seeds for the crisis were sown long before 2007. with a minimum of 18.adjusted mortgage rates accordingly. cash-out refinancing dummy. The effect is measured as the regression coefficient on the first-lien loan-to-value ratio (scaled by the standard deviation) in an ordinary least squares regression with the mortgage rate as the dependent variable and the FICO score.4 . second-lien loan-to-value ratio. defined as areas with median income below 80 percent of the larger Metropolitan Statistical Area median income.3 .2 . term of the mortgage. such as the combination of a high LTV ratio and a low FICO score.1 0 2001 FRM 2/28 Hybrid 2002 2003 2004 Year 2005 2006 2007 We show that our main results are robust to analyzing mortgage contract types separately. owner-occupation dummy. but detecting them was complicated by high house price appreciation between 2003 and 2005—appreciation that masked the true riskiness of subprime mortgages. and margin (only applicable to 2/28 hybrid) as independent variables. like allowing for interaction effects between different loan and borrower characteristics. we estimate our proportional odds model using data just through year-end 2005 and again obtain the continual deterioration of loan quality from 2001 onward. which seek to stimulate loan 4 . Figure 2: Sensitivity of Mortgage Rate to First-Lien Loan-to-Value Ratio The figure shows the effect of the first-lien loan-to-value ratio on the mortgage rate for first-lien fixed-rate and 2/28 hybrid mortgages. debt-to-income ratio. prepayment term. and specifying the empirical model in numerous different ways. missing debt-to-income ratio dummy. first-lien loan-to-value ratio. The latter includes taking into account risk-layering—the origination of loans that are risky in several dimensions. we find an increased probability of delinquency for loans originated in low. This points toward a negative by-product of the 1977 Community Reinvestment Act and Government Sponsored Enterprises housing goals. prepayment penalty dummy. Each point corresponds to a separate regression.5 . As an extension.

DellAriccia. and macroeconomic factors. dating back to at least Von Furstenberg and Green (1974). we uncover a downward trend in loan quality. First. and Willen (2008). borrower. securitizers were. determined as loan performance adjusted for differences in loan and borrower characteristics and macroeconomic circumstances. In Section 7 we analyze the subprime-prime rate spread and in Section 8 we conclude. Recent contributions include Cutts and Van Order (2005) and Pennington-Cross and Chomsisengphet (2007). There is a large literature on the determinants of mortgage delinquencies and foreclosures. Shapiro. and Laeven (2008). In Section 2 we show the descriptive statistics for the subprime mortgages in our database. as evidenced by changing determinants of mortgage rates. we detect an increased likelihood of delinquency in low. Campbell and Cocco (2003) and Van Hemert (2007) discuss mortgage choice over the life cycle.and moderate-income areas. 5 Deng. which led up to the 2007 subprime mortgage crisis. Fourth. The structure of this paper is as follows. Quigley. Second. Our paper makes several novel contributions. Mukherjee.and middle-income areas—might have created a negative by-product.origination in low. after controlling for differences in neighborhood incomes and other loan. 5 . Together these results provide evidence that the rise and fall of the subprime mortgage market follows a classic lending boom-bust scenario. in which unsustainable growth leads to the collapse of the market. This empirical finding seems to suggest that the housing goals of the Community Reinvestment Act and/or Government Sponsored Enterprises—those intended to increase lending in low. we quantify how much different determinants have contributed to the observed high delinquency rates for vintage 2006 and 2007 loans.and middle-income areas. In Section 6 we demonstrate the increasing riskiness of high-LTV borrowers. In Section 4 we present the baseline-case results and in Section 5 we discuss extensions and robustness checks. We further show that there was a deterioration of lending standards and a decrease in the subprime-prime mortgage rate spread during the 2001–2007 period. and Vig (2008). Fifth. In Section 3 we discuss the empirical strategy we employ. Third. we show that the continual deterioration of loan quality could have been detected long before the crisis by means of a simple statistical exercise. and the extent to which securitizers were aware of this risk. aware of this deterioration over time.5 Other papers analyzing the subprime crisis include Gerardi. that is associated with higher loan delinquencies. and Van Order (2000) discuss the simultaneity of the mortgage prepayment and default option. and Keys. Igan. We provide several additional robustness checks in the appendices. Our data enables us to show that the effect of different loan-level characteristics as well as low house price appreciation was quantitatively too small to explain the poor performance of 2006 and 2007 vintage loans. to some extent. Seru. Mian and Sufi (2008).

(more than half of the U.fdic. we discuss the delinquency rates of these loans for various segments of the subprime mortgage market. and the Office of Thrift Supervision use this definition. 61. which includes loan-level data on about 85 percent of all securitized subprime mortgages. and 75 percent respectively.9 We first outline the main characteristics of the loans in our database at origination. See e. or a 2/28 hybrid). In the second block of Table 1. specialization in high-cost loans). The term subprime can be used to describe certain characteristics of the borrower (e. 63. While it is not clear to us whether the pre. subprime loans are those underlying subprime securities. 76. The Office of the Controller of the Currency. however.7 lender (e. The total dollar amount originated in 2001 was $57 billion. 7 The Board of Governors of the Federal Reserve System. 9 Since the first version of this paper in October 2007.. some subprime lenders making prime loans and some prime lenders originating subprime loans. a FICO credit score less than 620). as of June 2008.2 Descriptive Analysis In this paper we use the First American CoreLogic LoanPerformance (henceforth: LoanPerformance) database.g. high projected default rate for the pool of underlying loans). while in 2006 it was $375 billion. in the wake of the subprime mortgage crisis.. In this paper.g. or mortgage contract type (e. We focus on first-lien loans and consider the 2001 through 2008 sample period.gov/news/news/press/2001/pr0901a.g. LoanPerformance has responded to the request by trustees’ clients to reclassify some of its subprime loans to Alt-A status.8 security of which the loan can become a part (e. Second.or post-reclassification subprime data are the most appropriate for research purposes.html 8 The U. We do not include less risky Alt-A mortgage loans in our analysis.S. The common element across definitions of a subprime loan is a high default risk. no money down and no documentation provided.6 There is no consensus on the exact definition of a subprime mortgage loan. In 2007. 76. Department of Housing and Urban Development uses HMDA data and interviews lenders to identify subprime lenders among them. the dollar amount originated fell sharply to $69 billion..g. the Federal Deposit Insurance Corporation.S.1 Loan Characteristics at Origination Table 1 provides the descriptive statistics for the subprime mortgage loans in our database that were originated between 2001 and 2007. In this version we focus on the post-classification data. we checked that our results are robust to the reclassification. subprime mortgage market). 6 Mortgage Market Statistical Annual (2007) reports securitization shares of subprime mortgages each year from 2001 to 2006 equal to 54. http://www. 6 .. we split the pool of mortgages into four main mortgage contract types.g. 2. In the first block of Table 1 we see that the annual number of originated loans increased by a factor of four between 2001 and 2006 and the average loan size almost doubled over those five years. and was primarily originated in the first half of 2007. There are.

2 42.2 41.3 180 23.1 19.1 70.9 6.9 212 19.7 6.1 200 18.5 29.7 6.3 620.2 8.1 82.3 8.4 6.6 39.7 618.5 37.0 34.5 8.2 43.3 0.4 6.2 Mortgage Type 27.6 0.0 0.3 63.4 72.6 6.3 83.7 8.8 74.9 41.3 66.4 73.4 12.4 59.5 7.8 41.8 30. 2001 2002 2003 2004 2005 2006 2007 Size Number of Loans (*1000) Average Loan Size (*$1000) FRM (%) ARM (%) Hybrid (%) Balloon (%) Purchase (%) Refinancing (cash out) (%) Refinancing (no cash out) (%) FICO Score Combined Loan-to-Value Ratio (%) Debt-to-Income Ratio (%) Missing Debt-to-Income Ratio Dummy (%) Investor Dummy (%) Documentation Dummy (%) Prepayment Penalty Dummy (%) Mortgage Rate (%) Margin for ARM and Hybrid Mortgage Loans (%) 452 126 33.2 2.5 8.9 0.2 0.9 8.5 5.0 7. 274 1.1 57.3 65.2 737 1.4 80.3 71. 258 1.6 59.8 0.3 57.2 85.3 75.4 51.9 79.7 70.8 618.3 6.7 58.0 7 .7 11.0 8.9 40.6 0.1 38.4 68.3 52.4 30.9 84.2 35.2 31.4 6.9 164 33.5 29.1 67.2 608.9 29.5 0.5 29.Table 1: Loan Characteristics at Origination for Different Vintages Descriptive statistics for the first-lien subprime loans in the LoanPerformance database.6 618.0 38. 911 2.5 75.8 56.0 11.9 9.1 613.1 82.2 66.2 8.2 76.7 8.2 62.5 7.4 316 220 Loan Purpose Variable Means 601.4 11.1 7.8 28.4 26.4 76. 772 145 29.4 75.4 54.5 25.8 0.4 38.8 4.3 8.7 6.

Less than 1 percent of the mortgages originated over the sample period were adjustable-rate (non-hybrid) mortgages. 10 8 . consistent with movements in both the 1-year and 10-year Treasury yields over the same period.Most numerous are the hybrid mortgages. For about a third of the loans in our database. the popularity of FRMs rose to 28 percent. In contrast. The proportion of balloon mortgage contracts jumped substantially in 2006. The share of loans with full documentation fell considerably over the sample period. accounting for more than half of all subprime loans in our data set originated between 2001 and 2007. The fixed-rate mortgage contract became less popular in the subprime market over time and accounted for just 20 percent of the total number of loans in 2006. by refinancing an existing mortgage loan into a larger new mortgage loan. The average FICO credit score rose 20 points between 2001 and 2005. single-family. The combined loan-to-value (CLTV) ratio. In the third block of Table 1. For example Koijen. purchase-money loans reported by the Federal Housing Financing Board in its Monthly Interest Rate Survey that are of the fixed-rate type fluctuated between 60 and 90 percent from 2001 to 2006. and accounted for 25 percent of the total number of mortgages originated that year. as the subprime mortgage crisis hit. and Van Nieuwerburgh (2007) show that the fraction of conventional. the purpose was to finance the purchase of a house. A hybrid mortgage carries a fixed rate for an initial period (typically 2 or 3 years) and then the rate resets to a reference rate (often the 6-month LIBOR) plus a margin. Finally. we report the purpose of the mortgage loans. Approximately 55 percent of our subprime mortgage loans were originated to extract cash. the margin (over a reference rate) for adjustable-rate and hybrid mortgages stayed rather constant over time. in the prime mortgage market. most mortgage loans were of the fixed-rate type during this period. A balloon mortgage does not fully amortize over the term of the loan and therefore requires a large final (balloon) payment. In about 30 to 40 percent of cases. fully amortizing. The (back-end) debtto-income ratio (if provided) and the fraction of loans with a prepayment penalty were fairly constant. In the final block of Table 1. slightly increased over 2001–2006. this is captured by the missing debt-to-income ratio dummy variable. Van Hemert. we report the mean values for the loan and borrower characteristics that we will use in the statistical analysis (see Table 2 for a definition of these variables). which measures the value of all-lien loans divided by the value of the house.10 In 2007. The share of loans originated in order to refinance with no cash extraction was relatively small. from 77 percent in 2001 to 67 percent in 2007. The mean mortgage rate fell from 2001 to 2004 and rebounded after that. primarily because of the increased popularity of second-lien and third-lien loans. Vickery (2007) shows that empirical mortgage choice is affected by the eligibility of the mortgage loan to be purchased by Fannie Mae and Freddie Mac. no debt-to-income ratio was provided (the reported value in those cases is zero).

we again plot the age pattern in the delinquency rate for vintages 2001 through 2007 and split the subprime mortgage market into various segments. the poor performance of the 2006 and 2007 vintages is not confined to a particular segment of the subprime market. As the figure shows. low-documentation. Delinquency rates in this 9 . and full-documentation mortgage loans. cash-out refinancing. In general. such as whether a mortgage broker intermediated. or in default.We do not report summary statistics on the loan source. We denote the ratio of the number of vintage k loans experiencing a first-time delinquency at age s over the number of vintage k loans with no first-time ˜k delinquency for age < s by Ps . purchase-money. real estate owned. where ˜k Ps (2) (3) i=2001 In Figure 1 (left panel) we show that for the subprime mortgage market as a whole. In Figure 3. the 2006 and 2007 vintages show the highest delinquency rate pattern. or the loan is reported as in foreclosure. vintage 2006 and 2007 loans stand out in terms of high delinquency rates. In Figure 4 we plot the delinquency rates of all outstanding mortgages. vintage 2001 loans come next in terms of high delinquency rates. In the six panels of Figure 3 we see that for hybrid. but rather reflects a (subprime) market-wide phenomenon. The delinquency rates for the fixed-rate mortgages (FRMs) are lower than those for hybrid mortgages but exhibit a remarkably similar pattern across vintage years. 2. We compute the actual (cumulative) delinquency rate for vintage k at age t as the fraction of loans experiencing a delinquency at or before age t t k Actualt = 1 − s=1 ˜k 1 − Ps (1) We define the average actual delinquency rate as t Actualt = 1 − ¯ Ps = 1 7 s=1 2007 ¯ 1 − Ps .2 Performance of Loans by Market Segments We define a loan to be delinquent if payments on the loan are 60 or more days late. as the broad classification used in the database rendered this variable less informative. Notice that the scale of the vertical axis differs across the panels. fixed-rate. and vintage 2003 loans have the lowest delinquency rates. Notice that the fraction of FRMs that are delinquent remained fairly constant from 2005Q1 to 2007Q2.

in foreclosure. The delinquency rate is defined as the cumulative fraction of loans that were past due 60 or more days. at or before a given age. Hybrid Mortgage Loans 35 30 25 20 15 10 5 0 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 Loan Age (Months) 5 0 3 4 5 6 2007 2006 2005 2004 2003 2002 2001 Fixed−Rate Mortgage Loans 25 20 15 10 2007 2006 2005 2004 2003 2002 2001 7 8 9 10 11 12 13 14 15 16 17 Loan Age (Months) Purchase−Money Mortgage Loans 40 35 30 25 20 15 10 5 0 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 Loan Age (Months) 5 0 3 4 2007 2006 2005 2004 2003 2002 2001 Cash−Out Refinancing Mortgage Loans 30 25 20 15 10 2007 2006 2005 2004 2003 2002 2001 5 6 7 8 9 10 11 12 13 14 15 16 17 Loan Age (Months) Full−Documentation Mortgage Loans 30 25 20 15 10 5 0 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 Loan Age (Months) 2007 2006 2005 2004 2003 2002 2001 Low−or−No−Doc Mortgage Loans 40 35 30 25 20 15 10 5 0 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 Loan Age (Months) 2007 2006 2005 2004 2003 2002 2001 10 . or defaulted.Figure 3: Actual Delinquency Rate for Segments of the Subprime Mortgage Market The figure shows the age pattern in the delinquency rate for different segments. real-estate owned.

caused by a decrease in the popularity of FRMs from 2001 to 2006 (see Table 1). who said “For subprime mortgages with fixed rather than variable rates. FRMs originated in 2006 in fact performed unusually poorly (Figure 3. Figure 4: Actual Delinquency Rates of Outstanding Mortgages The Figure shows the actual delinquency rates of all outstanding FRMs and hybrids from January 2000 through June 2008. serious delinquencies have been fairly stable. though. for example. the weaker performance of vintage 2006 loans is masked by the aging of the overall FRM pool. to realize that this result is driven by an aging effect of the FRM pool. Termination occurs either through a prepayment or a default. upper-right panel). we include delinquency—the earliest stage of payment problems—in our nonperformance measure.figure are defined as the fraction of loans delinquent at any given time. Given this focus on young loans. In other words. but if one plots the delinquency rate of outstanding FRMs over time (Figure 4. Our paper is related to the vast literature on empirical mortgage termination. for which we already have data for the vintages of particular interest: 2006 and 2007. Delinquency is an intermediate stage for a loan in trouble. not cumulative. These rates are consistent with those used in an August 2007 speech by the Chairman of the Federal Reserve System (Bernanke (2007)). Actual Delinquency Rate (%) 40 35 30 25 20 15 10 5 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 Year FRM Hybrid 3 Statistical Model Specification The focus of our paper is on the performance of subprime mortgage loans in the first 17 months after origination. An analysis of mortgage termination lends itself naturally to 11 .” It is important. the loan may eventually cure or terminate with a prepayment or default. left panel).

t log = αt + β xi.duration (i. and An (2006). The name “proportional odds” arises from the fact that the vector of coefficients. we define the probability that at age t loan i with covariate values xi.2 Estimation The proportional odds model. Important contributions to this literature include Deng (1997). does not have an age subscript and thus the log odds are proportional to the covariate values at any age. ran a standard logit regression. survival) models.t (5) where αt is an age-dependent constant and β is a vector of coefficients. Pennington-Cross (2003). and found qualitatively similar results for the effect of explanatory variables and the effect of vintage year dummies (unreported results).t 1 − Pi. is typically estimated for the full panel at once using either partial likelihood (see Cox (1972)) or maximum likelihood methodologies. Denoting this time by T . We apply the duration model methodology to the intermediate status of delinquency by defining nonsurvival as “having ever been 60 days delinquent or worse.. with prepayment and default as competing reasons for termination. The small sample properties for 12 . Ambrose and Capone (2000). Calhoun and Deng (2002). β.t becomes delinquent for the first time. Deng.” which includes formerly delinquent loans that are prepaid or cured. we use a proportional odds model.t } (4) Because the monthly choice whether to make a mortgage payment is discrete. the discrete-time analogue to the popular proportional hazard model: Pi. Transition from survival to non-survival will occur when a loan becomes 60 or more days delinquent or defaults for the first time. 3.e. conditional on not having been delinquent before. 3. Deng. Pavlov. and Pennington-Cross and Chomsisengphet (2007). and Van Order (2000). and Yang (2005). Deng. Equation 5. As a robustness check.1 Empirical Model Specification We are interested in the number of months (duration) until a loan becomes at least 60 days delinquent or defaults for the first time. we used “being currently 60 or more days delinquent or in default” as the non-performance measure.t = Pr {T = t|T ≥ t. Clapp. as Pi. xi. Quigley.

but for a sample size of 10. including the vintage 2007 dummy. For larger sample sizes the computational burden of the partial likelihood function quickly becomes unmanageable. they are left censored. αt . because we know for sure that they will never experience a first-time delinquency. if the securitizer goes out of business we stop observing their loans and therefore they are right censored. This is a result of heavily tied data in our discrete time setup.3 Reported Output The AgeEffect statistic is defined as the proportional odds ratio for first-time delinquency at a particular age t for the average (over the full sample) vector of covariate values at age t. see page 126 of Allison (2007). xt : ¯ AgeEffectt = exp (αt + β xt ) ¯ (6) The M arginal statistic is defined as the log proportional odds ratio associated with a one standard Loans securitized several months after origination are not observed in our data between the origination date and the securitization date. 000 loans the methods already provide very similar estimates for β. which has the added advantage that it provides estimates of the loan age effect.these two estimation methods are potentially different. the maximum likelihood estimation requires each covariate. In addition. 12 For more information on this. we classify prepaid loans as non-delinquent and non-censored. not due to a prepayment or default). We use the PROC LOGISTIC procedure in SAS for the maximum likelihood estimation. This method is able to handle both left censoring (loans entering the sample at a later age) and right censoring (loans leaving the sample prematurely. We use a random sample of 1 million loans for this exercise. where the term “tied” refers to loans experiencing first-time delinquency at the exact same age. Because we include vintage year dummies as covariates we have to restrict the maximum age considered in our analysis to 17 months. using the non-informative censoring assumption. the latest age for which we have an observation for the 2007 origination year.12 For the adjusted delinquency rate plots viewed at the end of 2005 and 2006 (Figure 5). have some dispersion in the covariate values for each age. We therefore estimate the proportional odds model using maximum likelihood.11 In order to generate unbiased delinquency rate plots (as in Figure 1. 3. we restrict the analysis to a maximum age of 11 months. right panel). 11 13 . therefore.

x01j . for vintage 2001 and variable j it is the difference between the mean value for variable j in 2001. σj : M arginalj = βj σj = log exp (αt + β xi.t + βj x01j − xj ¯ exp (αt + β xi. This property will be used for reporting the total contribution of all covariates in Table 3. the combined contribution of two variables is simply the sum of the individual contributions.t + βj σj ) exp (αt + β xi. expressed in the number of standard deviations of the variable. The probability of experiencing a first-time delinquency at or before age = t is given by t Pr {T ≤ t|xt . . we evaluate the above expression for the value of 14 . and the mean value over all vintages. xj .t ) ¯ Contributionj = βj x01j − xj = log (9) = M arginalj ∗ Deviationj As a straightforward generalization of Equation 9. xt−1 .} = 1 − s=1 (1 − Ps ) (10) To visualize the magnitude of the vintage year effect. expressed ¯ in the number of standard deviations: x01j − xj ¯ σj Deviationj = (8) The Contribution statistic measures the deviation of the (average) log proportional odds of first-time delinquency in a particular vintage year from the (average) log proportional odds of first-time delinquency over the entire sample that can be explained by a particular variable.t ) (7) The advantage of taking the log in Equation 7 is that the effect of an increase of σj in covariate j is minus the effect of a decrease of σj ..deviation increase in variable j. The Deviation statistic measures the difference between the mean value of a variable in a particular vintage year and the mean value of that variable measured over the entire sample. For example. For example for vintage 2001 and variable j we have: exp αt + β xi. and thus the absolute effect is invariant to the chosen direction of change.

The borrower and loan characteristics we use in the analysis are: the FICO credit score. a dummy variable indicating whether there is a prepayment penalty on a loan. originated between 2001 and 2007. All results in this section are based on a random sample of one million first-lien subprime mortgage loans. 4. a dummy variable indicating whether full documentation was provided. Dk = D. the (initial) mortgage rate. illustrated in Equation 5. 15 . Combining Equations 10 and Equation 11 we obtain the adjusted delinquency rate for vintage year k at age t t Adjustedk = 1 − t s=1 1 1+ ¯ Ps ¯ 1−Ps ¯ exp Dk − D (12) ¯ Notice that for an average vintage year. a dummy variable indicating whether the loan was a cash-out refinancing. Equation 12 simplifies to t Adjustedt = 1 − s=1 ¯ 1 − Ps = Actualt (13) 4 Empirical Results for the Baseline-Case Specification In this section we investigate to what extent the proportional odds model model can explain the high levels of delinquencies for the vintage 2006 and 2007 mortgage loans in our database.1 Variable Definitions Table 2 provides the definitions of the variables (covariates) included in the baseline-case specification of the proportional odds model. including vintage year dummies. a dummy variable indicating whether the borrower was an investor (as opposed to an owner-occupier). a dummy variable indicating whether the debt-to-income ratio was missing (reported as zero).Ps that satisfies log Ps 1 − Ps = log ¯ Ps ¯ 1 − Ps ¯ + Dk − D (11) ¯ where Dk is the estimated coefficient for for the vintage year k dummy variable and D is the average estimated vintage dummy variable. the value of the debt-to-income ratio (when provided). the combined loan-to-value ratio. This expression uses the proportional odds property for explanatory variables.

at origination.Table 2: Baseline-Case Variable Definitions This table presents definitions of the baseline-case variables (covariates) used in the proportional odds duration model. applicable after the first interest rate reset. Equals one if the mortgage loan is a cash-out refinancing loan. ARMs. MSA-level house price appreciation from the time of loan origination. We have no clear prior on the effect of the origination amount on the probability of delinquency. reported by the Bureau of Economic Analysis. We expect that a prepayment penalty makes refinancing less attractive. Equals one if the back-end debt-to-income ratio is missing and zero if provided. holding constant the loan-to-value and debt-to-income ratio. Census Bureau 2000. Debt-to-Income Ratio (+) Missing Debt-to-Income Dummy (+) Cash-Out Dummy (-) Investor Dummy (+) Documentation Dummy (-) 16 Prepayment Penalty Dummy (+) Mortgage Rate (+) Margin (+) Product Type Dummies (+) Origination Amount (?) House Price Appreciation (-) Change Unemployment Rate (+) Neighborhood Income (-) . A higher interest rate makes it harder to make the monthly mortgage payment. Back-end debt-to-income ratio. An increase in the state unemployment rate increases the probability a homeowner lost his job. We report the expected sign for the independent variables in parentheses and sometimes provide a brief motivation. Zip-code-level median income in 1999 from the U. reported by the Office of Federal Housing Enterprise Oversight (OFHEO).S. We consider four product types: FRMs. which therefore have the interpretation of the probability of delinquency relative to FRM. We include a dummy variable for the latter three types. we expect positive signs for all three product type dummies. Equals one if the borrower is an investor and does not owner-occupy the property. A higher debt-to-income ratio makes it harder to make the monthly mortgage payment. Initial interest rate as of the first payment date. Size of the mortgage loan. Higher housing equity leads to better opportunities to refinance the mortgage loan. Margin for an adjustable-rate or hybrid mortgage over an index interest rate. Equals one if there is a prepayment penalty and zero otherwise. as proxied by the median income. which increases the probability of financial problems. Equals one if full documentation on the loan is provided and zero otherwise. Pennington-Cross and Chomsisengphet (2007) show that the most common reasons to initiate a cash-out refinancing are to consolidate debt and to improve property. the more motivated a borrower may be to stay current on a mortgage. Hybrids. defined by the total monthly debt payments divided by the gross monthly income. Explanation FICO Score (-) Combined Loan-to-Value Ratio (+) Combined value of all liens divided by the value of the house at origination. and Balloons. State-level change in the unemployment rate from the time of loan origination. Because we expect the FRM to be chosen by more risk-averse and prudent borrowers. Variable (Expected Sign) Fair. Isaac and Company (FICO) credit score at origination. We expect the lack of debt-toincome information to be a negative signal on borrower quality. A higher margin makes it harder to make the monthly mortgage payment. We expect full documentation to be a positive signal on borrower quality. The better the neighborhood. A higher combined loan-to-value ratio makes default more attractive. The first two variables are used as dependent variables. The other variables are used as independent variables.

2 Determinants of Delinquency In Tables 3.and the margin for adjustable-rate and hybrid loans. or. 14 Estimating house price appreciation on the MSA-level.94 percent.4794) = 0. the combined loan-to-value ratio. To the best of our knowledge. and house price appreciation. Census Bureau 2000 and are collected every 10 years. a one standard deviation increase in the FICO score decreases the log odds of first-time delinquency by 47. The product type has a relatively small effect on the performance of a loan. the mortgage rate. All marginal effects have the expected sign. reported by the Bureau of Economic Analysis. To this end we use metropolitan statistical area (MSA) level house price indexes from the Office of Federal Housing Enterprise Oversight (OFHEO) and match loans with MSAs by using the zip code provided by LoanPerformance. defined as the house price accumulation in the year prior to the loan origination. Third. Column two documents the marginal effect of the covariates (Equation 7). The tables report the output of a single estimation. These variables were not significant and did not materially change the regression coefficients on the other variables. as shown in Table 2.13 In addition.S. In Figure We also studied specifications that included loan purpose. we construct a variable that measures house price appreciation from the time of origination until the time we evaluate whether a loan is delinquent. equivalently. due to limited page size. The four explanatory variables with the largest (absolute) marginal effects and thus the most important for explaining crosssectional differences in loan performance. for example. In Table 2 we report the expected sign for the regression coefficient on each of the explanatory variables in parentheses. 4 and 5 we present the determinants of delinquency using the proportional odds methodology.6192. According to the estimates. we use a measure for the quality of the neighborhood: zip-code-level median household income in 1999. we include the state-level change in the unemployment rate from the time of loan origination until the time of performance evaluation. An increase in the state unemployment rate increases the probability a homeowner lost his or her job. are the FICO score. which increases the probability of financial problems. First. changes the odds by a factor exp(−0. the output is spread over three separate tables. and housing outlook. The first column of Table 3 lists the covariates included (other than the vintage and age dummies which are reported in Tables 4 and 5). there is no data available to estimate the size of this measurement error or to evaluate its impact on the results. Except for the hybrid and ARM dummies. as opposed to the individual property level introduces a potential measurement error of this variable. 4. we use three macro variables in the baseline-case specification. The data are from U. all variables are statistically significant at the 1% level. The better the neighborhood the more motivated a borrower may be to stay current on a mortgage.14 Second. reported in Table 1. beyond what is explained by other characteristics. 13 17 .

15 18 . high house price appreciation contributed to a reduced probability of delinquency compared to a situation with average covariate values. the total Consistent with this finding. left panel). relatively low house price appreciation.16 By construction.15 The contributions of each covariate to explaining different delinquency rates for each vintage year are given in columns 3 through 9 of Table 3. and 2001 was the year with the third-highest rates (see Figure 1. As shown in Table 4. For vintage years 2003 and 2005. the equal-weighted average contribution is not zero. except for the small increase from 2006 to 2007. which is computed using Equation 12.71 percent increase in the log odds of delinquency. LaCour-Little (2007) shows that individual credit characteristics are important for mortgage product choice. the coefficients of the vintage dummy variables increase every year.3 we show that FRMs experience a much lower delinquency rate than hybrid mortgages. 16 Shiller (2007) argues that house prices were too high compared to fundamentals in this period and refers to the house price boom as a classic speculative bubble largely driven by an extravagant expectation for future house price appreciation. where 2003 was the year with the lowest delinquency rates. This picture is in sharp contrast with that obtained from actual rates. Therefore. high mortgage rates.09 percent for vintage 2007—years for which low house price appreciation and high mortgage rates increased the probability of delinquency. The very high delinquency rate for vintage 2001 loans can be explained in large part by a near perfect storm of unfavorable lending and economic conditions: low FICO scores. For example. we can say that high house price appreciation between 2003 and 2005 masked the true riskiness of subprime mortgages for these vintage years. The vintage dummy coefficients reported in Table 4 are in the same units as the contribution of the different variables presented in Table 3. comparing vintages 2001 and 2007. which demonstrates that loan quality deteriorated after adjusting for the other covariates included in the specification. all contributing to a higher probability of delinquency. This deterioration is illustrated by the adjusted delinquency rates depicted in Figure 1 (right panel). compared to a situation with average covariate values.06 percent for vintage 2006 and slightly smaller than the 56. Because the number of loans originated differs across vintages years. hence rows for the contribution variable in Table 3 do not add up to zero. which therefore must be driven by borrowers with better characteristics selecting into FRMs. with weights equal to the number of originated loans in a particular vintage year. This is slightly higher than the 45. and low (negative) change in unemployment. We test whether the differences between every subsequent vintage year dummy coefficients are statistically significant. the weighted-average contribution of a variable over 2001–2007 is zero. the different covariates contributed to a 51. In total. We find that the yearly change (increase) in the dummy variables are statistically significant at the 1% confidence level.

69∗ −8.51 −0.23 0.34 −0.36 2001 2002 2003 2004 2005 2006 Marginal Effect.00 −8. The first column reports the covariates included.07 −0.00 2.20 0.01 −0. Columns three through nine detail the contribution of a variable to explain a different probability of delinquency in 2001–2007 (Equation 9).94∗ 24.35 0.37 16.71 3. The second column reports the marginal effect.29 −1.17 2.40 −3.49 0.86∗ −13.19 −9.92 −2.86 5.46 11.05 5.11 17. defined in Equation 7. Variables Other Than Vintage and Age Dummy Variables The table shows the output of the proportional odds duration model.04 13.40 −2.54 0.02 0.55 −34.Table 3: Determinants of Delinquency.94 −2.73 −0.32 −2.63 0.96∗ 7.32 −0.59 0.31 21.64 −1.00 −0.03 7.69 2.79∗ 6.25 0.02 −0.74 −0.32 0.08 32.24 12.00 −0. % Contribution.11 0.42 −1.23 2.90 −0.29 0.93 0.24 −0.66 −7.85 −0.04 −0. other than the vintage and age dummies which are reported separately in Table 4.84∗ 1.38 56.51 0.36 3.40 0.04 0.81∗ − −2.00 3.13∗ 29.43 0.09 −1.38 2.67 0.35 0. % 2007 3.68 0.78 −4.44 −5.02 −0.95 0.86 0.09 FICO Score −1.18 0.48 3.60 −0.00 2.74 6.81 0.81 −0.78 −0.03 −0.31 −5.52 0.86 0.00 39.18 −1.03 0.01 −2.32 −10.50 0.99 −27.10 0.48 2.48 45.31 −0.19 0.53 −0.91∗ −29.02∗ 12.12 −0.05 −0.73∗ 3.25 0.85 −2.04 Combined Loan-to-Value Ratio Debt-to-Income Ratio Missing Debt-to-Income Dummy Cash-Out Dummy Investor Dummy 19 Documentation Dummy Prepayment Penalty Dummy Mortgage Rate Margin Hybrid Dummy ARM Dummy Balloon Dummy Origination Amount House Price Appreciation Change Unemployment Neighborhood Income Total .78 −13.95 4.03 0.52 −16.76 51.59∗ −12.06 0.43 2.06 −0.16 −0.76 −2.40 −2.53 −0.62 1. Explanatory Variable 2001–2007 −47.34 13.01 −0.00 −3.00 −0.71 −7. A “∗” indicates statistical significance at the 1% level.00 −1.21∗ 11.24 −2.11 −0.98 −0.70∗ 15.86∗ 12.03 0.52 0.31 −0.

73 0. The first column reports the vintage dummies included. A “∗” indicates statistical significance at the 1% level. Months 3 4 5 6 7 8 9 10 AgeEffect (*100) 0. estimated for each age dummy variable based on Equation 6. The second column shows the estimated coefficients. Vintage Dummy Variables The table shows the output of the proportional odds duration model. The vintage 2001 dummy was not included as covariate.67 0.73 0.73 0.55 0.93∗ 64.70 0. The values for the other covariates are reported in Tables 3 and 4.69 0.00 5.72 0.71 0.64∗ 49. Each column reports the corresponding odds ratio. Explanatory Variable Estimate. AgeEffect. hence the coefficients on the other covariates are relative to the 2001 vintage and we report a zero value for the coefficient of 2001.12∗ 23.69∗ Table 5: Determinants of Delinquency. Age.72 0.65∗ 66.31 0. The values for the other covariates are outlined in Tables 3 and 5.67 – 20 .72 0. Age Dummy Variables The table shows the output of the proportional odds duration model. Months 11 12 13 14 15 16 17 – AgeEffect (*100) 0.04 0.Table 4: Determinants of Delinquency.72 Age. % Vintage 2001 Vintage 2002 Vintage 2003 Vintage 2004 Vintage 2005 Vintage 2006 Vintage 2007 0.71∗ 57.

Moreover. plus the 10 interaction and quadratic terms that can be constructed from the four most important variables: the FICO score.17 The finding of a continual decline in loan quality also occurs when analyzing foreclosure rates (Appendix A). in Table 5 we report the odds statistic defined in Equation 6. Moreover. This pales in comparison to the 66.1 Different Loan and Borrower Characteristics We explore numerous alternative loan and borrower characteristics as covariates for robustness. the deterioration is clearly visible. We therefore conclude that the dramatic deterioration of loan quality in this decade should have been apparent by the end of 2005. because the computation of the adjusted delinquency rate for. makes use of a regression model estimated using data from 2001 through 2008.69 percent increase in the vintage dummy variable over 2001–2007. we consider as covariates those of the baseline case presented in Table 3.contribution of the (non-vintage dummy) covariates increased by 4. To illustrate the effect of age on the conditional probability of first-time delinquency.71 percent to 56. say. and analyzing hybrid mortgages and FRMs separately (Appendix B). the CLTV ratio. Figure 5 (right panel) depicts the situation when we use data available at the end of 2006. vintage 2001 loans. Again.09 percent).38 percent (from 51. First. a short position is associated with a high cost of carry (Feldstein (2007)). 5 Empirical Results for Alternative Specifications In this Section we explore various alternative model specifications. was the dramatic deterioration of loan quality since 2001 already apparent? Notice that we cannot answer this question by simply inspecting vintages 2001 through 2005 in Figure 1 (right panel). The resulting age pattern in adjusted delinquency rates is plotted in Figure 5 (left panel). 17 21 . One reason why investors did not massively start to avoid or short subprime-related securities is that the timing of the subprime market downturn may have been hard to predict. Next we study the following question: Based on information available at the end of 2005. we re-estimate the proportional odds model underlying Figure 1 (right panel) making use of only 2001–2005 data. the main result documenting the monotonic rise in adjusted delinquency rates is found based on numerous alternative model specifications discussed in Section 5. 5. We see that the odds of first-time delinquency peaks around age of 7–13 months. Hence. We again obtain the result that the adjusted delinquency rate rose monotonically from 2001 onward.

Viewed at the End of 2005 and 2006 The figure shows the adjusted delinquency rate using data available at the end of 2005 (left panel) and 2006 (right panel). cash-out refinancing dummies. documentation levels. Adjusted Delinquency Rate (%). at or before a given age. owneroccupation dummies. margins. End of 2005 16 14 12 10 8 6 4 2 0 3 4 5 6 7 8 Loan Age (Months) 9 10 11 2005 2004 2003 2002 2001 Adjusted Delinquency Rate (%). missing debt-to-income ratio dummies. MSA house price appreciation since origination.Figure 5: Adjusted Delinquency Rate. origination amounts. change in state unemployment rate since origination. The adjusted delinquency rate is obtained by adjusting the actual rate for year-by-year variation in FICO scores. or defaulted. percentage of loans with prepayment penalties. mortgage rates. debt-to-income ratios. loan-to-value ratios. real-estate owned. End of 2006 16 14 12 10 8 6 4 2 0 3 4 5 6 7 8 Loan Age (Months) 9 10 11 2006 2005 2004 2003 2002 2001 22 . in foreclosure. and neighborhood median income. The delinquency rate is defined as the cumulative fraction of loans that were past due 60 or more days. composition of mortgage contract types.

referring to a situation where an investor takes out a second-lien loan not reported in our database typically in combination with an 80 percent first-lien loan. We find that the coefficient on the FICO-CLTV interaction term is close to zero and insignificant. we take into account the effect of risk-layering—such as. Allowing for these additional terms. We find that the coefficient is positive and statistically significant and that it inherits some of the statistical power of the CLTV variable. are statistically and economically similar to those based on the entire sample of loans. This dummy variable is statistically significant but economically not very large and moreover hardly improved the overall fit. Inclusion of the dummy does not substantially increase the overall fit of the model. Third. Fourth. for example. as measured by the log likelihood ratio. we included a dummy for the presence of a second-lien loan. Fifth. The estimates based on the smaller subsample.the mortgage rate. the effect of a combination of a borrower’s low FICO score and a high CLTV ratio—on the probability of delinquency. because the borrower is closer to a situation with negative equity in the house (combined value of the mortgage loans larger than the market value of the house). we are aiming to control for silent seconds. we performed several robustness checks regarding the reset rate for hybrid mortgages. A negative sign would mean that a low FICO and a high CLTV reinforce each other and give rise to a predicted delinquency probability that is higher than that without interaction effect. The 23 . and subsequent house price appreciation. we find a negative and significant (at the 1% level) coefficient on this interaction term. Consistent with this intuition. With this variable. It is in this case not a priori clear what the sign on the FICO-CLTV interaction variable should be. Second. we considered as an additional covariate a dummy variable taking the value one whenever the CLTV equals 80 percent. The vintage dummy variables are still increasing every year. Inclusion of the 10 interaction covariates does not substantially increase the overall fit of the model. we excluded the loans where the debt-to-income ratio is missing from the sample to make sure the measurement error associated with this variable does not lead to a significant bias in the results. More certain is the sign we expect on the HPA-CLTV variable. as measured by the log likelihood ratio. A positive sign could be explained by lenders who originate a low FICO and high CLTV loan only if they have positive private information on the loan or borrower quality. Low house price appreciation is expected to especially give rise to a higher delinquency probability for a high CLTV ratio. in which the debt-to-income variable has non-zero reported values. The coefficients of the other covariates are virtually unchanged.

First. 19 For more details on this procedure.60 percent for the two alternative specifications respectively. we include the post-reset margin as an additional covariate in the baseline case specification. We performed two additional robustness checks. the marginal effects for the margin covariates in the baseline case are 11. For FRMs the values of the new covariates are set to zero. Second. The log likelihood of the different specifications is virtually identical. the duration of the initial fixed rate period is 24 months or more.21 percent in the baseline case. 18 24 . 5. This captures the potential change in interest rate at the time of reset. and in both cases obtain our main result that adjusted delinquency rates rose monotonically over 2001–2007 (see Figure 9). see the official OFHEO documentation by Calhoun (1996). The margin is in excess of a reference rate. followed by 36 months. Since we focus on delinquency in the first 17 months.84 percent.18 OFHEO uses a repeated-sales methodology to compute house price appreciation in a geographical unit (like a state or MSA) and. instead of the margin we included a covariate defined as the margin plus the 6-month LIBOR interest rate at origination (obtained from Bloomberg). compared to a marginal effect of 29. as reported in Table 3. the most common fixed period is 24 months. as a by-product.34 percent of the cases is the 6-month LIBOR rate. which in 99. We obtained the data from the Office of Federal Housing Enterprise Oversight (OFHEO) at the state level. as reported in Table 3. However. instead of the margin we included a covariate defined as the margin plus the 6-month LIBOR interest rate at origination minus the initial mortgage rate. because households may have factored in the rise in the mortgage rate before the actual reset date. we expect the initial mortgage rate to be an important covariate. MSA-level data exist but was not available for public release. Among the other covariates. and Van Hemert (2008) explain the interpretation and computation of the volatility parameters. only the coefficient for the initial rate is slightly affected.19 We would like to thank OFHEO for providing us with the data.58 percent and 33. The marginal effect for the two new covariates is 12.83 percent respectively.27 percent and 7. based on the 6-month LIBOR rate at origination. For 99. As a robustness check we performed the analysis for FRMs and Hybrid mortgages separately. Also De Jong.57 percent of mortgages in our database. with FRMs not being subject to resets. Driessen. obtains an estimate of the variation of the return around the mean in the geographical unit.initial mortgage rate for hybrid mortgages is potentially lower during the initial fixed-rate period. The marginal effect of the initial rate is 29.2 Local house-by-house return volatility In this section we study local house-by-house return volatility as as additional covariate.

75 percent. annualized and averaged over the full panel (50 states plus the District of Columbia in the 2001Q1-2008Q2 sample period). 5. The standard deviation of the volatility estimate over time (averaged over the 50 states plus the District of Columbia) is only 0. in the empirical implementation we add both the house-by-house return volatility by itself and the interaction of this volatility with HPA as covariates. but indicates that the evaluation process should accommodate the situation and 25 . based on house price appreciation in the geographical area. the estimated coefficient on the interaction term is positive.3 CRA and GSE Housing Goals In this section we explore additional covariates related to the Community Reinvestment Act (CRA) and Government Sponsored Enterprises (GSEs) housing goals. When the equity is positive based on house price appreciation in the geographical area. The 1977 Community Reinvestment Act (CRA) is a United States federal law designed to encourage commercial banks and savings associations to meet the needs of borrowers in all segments of their communities. the higher the probability an individual house has negative equity. the higher the house-by-house return volatility.05 percent. there is a 50 percent probability the household actually has negative equity based on the (unobserved) house price appreciation of the individual house. The CRA does not list specific criteria for evaluating the performance of financial institutions. and Huszar (2005). normal) distribution for the house-by-house deviation from the MSA mean.The house-by-house volatility is 8.18 percent.and moderate-income (LMI) households and neighborhoods. LaCour-Little. While it is not just the probability of having negative equity for an individual house that matters. the situation is reversed. and Huszar (2005) use the volatility estimate of OFHEO to compute the probability of negative equity. In the special case that the equity in the house is exactly zero. LaCour-Little. The effect is statistically significant at the 1% level. including low.g. Ambrose. Hence. when house price appreciation is high in the geographical area. but has a small Chi-squared statistic compared to the baseline case covariates and has a negligible impact on the coefficients of the other covariates. Most of the variation of the volatility is in the cross-section: the standard deviation of the volatility estimate across states (averaged over 2001Q12008Q2) is 0. it does seem intuitive that the effect of local house-byhouse return volatility may interact with HPA.. but in general the whole probability distribution. When the equity is negative. high volatility increases the probability of having negative equity for a specific house. Consistent with Ambrose. assuming a symmetric (e.

We either include an LMI dummy that equals one if the median neighborhood income is less than 80 percent of the MSA median income.context of each individual institution. LoanPerformance data identifies each property location in zip codes. An institution’s CRA compliance record is. The goals are primarily defined in terms of (i) household income relative to median MSA income (for urban neighborhoods). and (iii) minority concentration in the neighborhood. Census Bureau to compute the LMI dummy. In specification II we add the MSA median income to the baseline case covariates.pdf Table 1 for the specific goals for 2000-2006. poverty level. 21 20 26 . The results are presented in Table 6. including the neighborhood median income. CRA and GSE targeted communities are defined using census tract-level measures (such as income.org/Datasets/GSE/gse2006. controlling for the baselinespecification covariates. Therefore.23 The LMI dummy or MSA median income level pick up the difference in the probability of delinquency for loans in MSAs with different median incomes. (ii) neighborhood median income relative to MSA median income. 22 See http://www. Of the baseline case covariates. thus we cannot identify the CRA targeted community. for example. e. giving rise to different incentives for CRA-complying institutions and the GSEs. A higher See http://www. We interpret any effect from the LMI dummy or MSA median income to come from the CRA and GSE housing goals. 23 The precise identification of CRA and GSE targeted neighborhoods is not feasible in our analysis for several reasons: (i) the location of subprime lenders is not reported in the LoanPerformance data. we only report the neighborhood income to preserve space. the MSA for urban neighborhoods. taken into account when applying for deposit facilities.gov/dcca/cra/ See Laderman (2004) for a further discussion. Specification I corresponds to the baseline case of Table 3 and is included as a benchmark.S.huduser. or we add the MSA median income.22 To isolate the effect of CRA and the GSE housing goals from pure neighborhood effects..federalreserve. which do not directly match with census tracts.21 With a similar objective of helping poor and underserved individuals and neighborhoods. we study the effect of LMI neighborhood status on the probability of delinquency. and thus assume that there is no direct effect of LMI status or MSA median income on borrower behavior after controlling for neighborhood median income. and minority concentration). in our analysis we identify neighborhoods that can potentially fall under CRA and GSE housing goals using either the LMI dummy variable or MSA-level median household income.20 LMI neighborhoods have a median income level that is less than 80 percent of the median income of a broader geographic area.g. and (ii) most frequently. We use zip-code level median household income and median MSA household income from the U. but in neighborhoods with the same median income and with the same loan and borrower characteristics. the Congress in 1992 established an affordable housing mission for Fannie Mae and Freddie Mac by directing the Department of Housing and Urban Developement (HUD) to create specific mortgage purchase goals for these Government Sponsored Enterprises (GSEs).

if it is a low..79%∗ 3. I Neighborhood Income MSA Income LMI Dummy LMI 2001 LMI 2002 LMI 2003 LMI 2004 LMI 2005 LMI 2006 LMI 2007 II III IV −8. A “∗” indicates statistical significance at the 1% level. The positive and statistically significant (at the 1% level) marginal effect reported in the table effect thus implies that CRA and GSE housing goal eligibility is associated with a higher probability of delinquency.and moderate-income (LMI) neighborhood. i.64%∗ 2.07%∗ − − − − − − − − − 2. The marginal effect for the interaction terms is computed as the product of the estimated coefficient and the full sample standard deviations of LMI.67%∗ 1. Finally in specification IV we interact the LMI dummy with vintage dummies to see how the LMI effect changed over time.82%∗ − − − − − − − − − 6.94%∗ − − − − − − − − − 1. Table 6: Low. In specification III we add the LMI dummy to the baseline case covariates.and Moderate-Income Neighborhood Effect This table reports marginal effects for different measures of neighborhood (median household) income relative to MSA (median household) income. In all four specifications we include the baseline case variables used in Table 3.95%∗ −6. of which we only report neighborhood income to preserve space. Specification I is the baseline case with no variable capturing the neighborhood income relative to the MSA income. Specification III includes a dummy with value one if neighborhood income is less than 80 percent of MSA income.75% 3.81%* −9.MSA median income increases the possibility a loan was made to advance CRA or GSE housing goals. Specification IV includes interaction variables of the LMI dummy with vintage year dummies.79%∗ 27 . There is no clear trend over time.10%∗ −6.26%∗ 4.52%∗ 1.e. ceteris paribus. We find a positive and significant marginal effect. For all vintage years the marginal effect is positive and statistically significant at the 1% level. which is positive and statistically significant at the 5% level. except for 2003. Specification II includes MSA income. again implying that CRA and GSE housing goal eligibility raises the probability of delinquency.

The combined LTV ratio rather than the first-lien LTV ratio is believed to be the main determinant of delinquency because it is the burden of all the debt together that may trigger financial problems for the borrower. first-lien loan-to-value ratio. 25 24 28 . the CLTV is an increasingly important determinant of delinquency over time. including the first-lien LTV and second-lien LTV (CLTV minus first-lien LTV). That is. We examine whether lenders were aware that high LTV ratios were increasingly associated with riskier borrowers. and loan characteristics. for example. 0. term of the mortgage.15. We estimate the proportional odds model with CLTV interacted with the seven vintage dummy variables. Hence. 0. origination amount.25 We perform one such regression for each calendar quarter in our sample period. the effect of a unit change in a given covariate on the probability of first-time delinquency is the same in. a cash-out refinancing dummy. instead of just CLTV without interaction.14. 0. as independent variables.34 for years 2001 to 2007. a dummy for owner occupation. documentation dummy. In contrast. as we have in the baseline case specification (Section 4). 0. which totals 0. a dummy for a missing debt-to-income ratio. To conserve space the results are not reported.22. by investigating the relationship between the loan-to-value ratio and mortgage rates over time. as it is in 2001. holding constant the values of the other covariates. 2006. margin. We can only expect to get accurate results when using relatively homogeneous groups of loans.10. second-lien loan-to-value ratio. and therefore consider fully amortizing FRM and 2/28 hybrid loans separately. prepayment penalty dummy. we use the FICO score. and prepayment term as the righthand-side variables.6 Non-Stationarity of the Loan-to-Value Effect The proportional odds model used in Section 4 assumes that the covariate coefficients are constant over time. Together these two contract types account for more than half of all mortgage loans in This is confirmed by our empirical results. respectively. the first-lien LTV is the more important determinant of the mortgage rate on a first-lien mortgage. All seven coefficients are highly statistically significant at the 1% level. because it captures the dollar amount at stake for the firstlien lender. debt-to-income ratio.24 For this reason. In this section we first discuss this finding and then turn to the question of whether lenders were aware of the non-stationarity of the loan-to-value effect. Specifically. 0. we test whether the sensitivity of the lender’s interest rate to the firstlien LTV ratio changed over time.35. 0. We compute the marginal effect for a particular loan vintage as the product of the estimated coefficient for the associated interaction variable and the standard deviation of CLTV for all vintages together. We test the validity of this assumption for all variables in our analysis and find that the strongest rejection of a constant coefficient is for the CLTV ratio.11. We perform a cross-sectional OLS regression with the mortgage rate as the dependent variable.

Figure 2 shows the regression coefficient on the first-lien LTV ratio for each quarter from 2001Q1 through 2007Q2. and they can therefore be interpreted as the changes in the mortgage rates when the first-lien LTV ratios are increased by one standard deviation. This provides evidence that lenders were to some extent aware of high LTV ratios being increasingly associated with risky borrowers.fhfb. In this section we analyze the time series of the subprime-prime rate spread. In Figure 6 we show the actual subprime-prime rate spread. respectively. For hybrid mortgages the subprimeprime comparison is more complicated because (i) both the initial (teaser) rate and the margin should be factored in. We focus on FRMs for this exercise.27 In Appendix C we show that this result is robust to allowing for a non-linear relationship between the mortgage rate and the first-lien LTV ratio. both with and without adjustment for changes in loan and borrower characteristics. but due to a near shutdown of the securitized subprime mortgage market we lack statistical power in this quarter. as unreported results suggest.our database. 26 29 .gov/GetFile. the corresponding rate increase was 10 and 16 basis points. notice that the effect of a one-standard-deviation increase in the first-lien LTV ratio on the 2/28 mortgage rate increased substantially in the wake of the subprime mortgage crisis: from 30 basis points in 2007Q1 to 42 basis points in 2007Q2. keeping constant other loan characteristics.28 The subprime-prime spread—the difference between the average subprime and prime rates—decreased Our data extends to 2007Q3. interest rates on subprime mortgages are higher than on prime mortgages to compensate the lender for the (additional) default risk associated with subprime loans. In the fourth quarter of 2006. 27 The effects of other loan characteristics on mortgage rates have been much more stable over time. 28 Available at http://www. the prime rate is the contract rate on FRMs reported by the Federal Housing Finance Board (FHFB) in its Monthly Interest Rate Survey. Each cross-sectional regression is based on a minimum of 18. a one-standard-deviation increase in the first-lien LTV ratio corresponded to about a 30-basis-point increase in the mortgage rate for 2/28 hybrids and about a 40-basis-point increase for FRMs.784 observations.aspx?FileID=6416. 7 Subprime-Prime Rate Spread In general. in the first quarter of 2001. and (ii) we don’t have good data on the prime initial rates and margins. Finally. defined in Equation (15) below. The subprime rate for this exercise is calculated as the average across individual loans initial mortgage rate for each calendar month (the data source is LoanPerformance).26 We scaled the coefficients by the standard deviation of the first-lien LTV ratio. In contrast.

which coincides with the most rapid growth in the number of loans originated (see Table 1).5 2 1. origination amount. hence the decline cannot just be attributed to a change in the overall level of risk aversion. etc. 3. with the largest decline between 2001 and 2004. a dummy variable that equals one if a borrower is an investor. the actual subprime-prime rate spread declined much more and more steadily. third. a dummy variable that equals one if prepayment penalty is present. In Figure 6 we also plot the yield spread between 10-year BBB and AAA corporate bonds. using data from 2001 through 2006. value of debt-to-income ratio. a dummy variable that equals one if full documentation was provided.substantially over time. a dummy variable that equals one if loan is a refinancing. which we obtained from Standard and Poor’s Global Fixed Income Research. loan-to-value ratio based on a first-lien. spreadit = subprimeit − primet (14) (15) Notice that the β1 primet term corrects for the fact that the spread is affected by the prime rate itself.29 spreadit = β0 + β1 primet + β2 characteristicsit + errorit . and loan-to-value ratios based on a second. and thus changes over the business cycle.5 0 2001 Subprime−Prime Spread (%) BBB−AAA Spread (%) 2002 2003 2004 Year 2005 2006 2007 We perform a cross-sectional OLS regression with the loan-level spread as the dependent variable and the prime rate and various subprime loan and borrower characteristics as the explanatory variables. Compared to the corporate BBB-AAA yield spread.5 1 . 29 30 . liens if applicable. Figure 6: FRM Rate Spread and Corporate Bond Yield Spread The figure shows the FRM subprime-prime rate spread and the yield spread between 10-year BBB and AAA corporate bonds.5 3 2. because a higher prime rate increases the default probability The explanatory factors in the regression are the FICO credit score. a dummy variable that equals one if debt-to-income was not provided.

In Figure 1 (right panel) we showed that loan quality. along with a fitted linear trend. third. averaged per origination month t. Figure 7: Prediction Error in the Subprime-Prime Rate Spread The figure shows the prediction error in the subprime-prime rate spread. obtained by adjusting loan performance for differences in loan and borrower characteristics and subsequent house price appreciation. . determined in a regression of the spread on the prime rate and the following loan and borrower characteristics: the FICO credit score.on subprime loans for a given spread. value of debt-to-income ratio. a dummy variable that equals one if debt-to-income was not provided.75 . a dummy variable that equals one if the loan is a refinancing. origination amount. a dummy variable that equals one if full documentation was provided. after adjusting for differences in observed loan and borrower characteristics.25 −. deteriorated over the period. liens if applicable. a dummy variable that equals one if a prepayment penalty is present. the loan-to-value ratio based on a first lien.5 . etc. argue that this was facilitated by the development of so-called private-label mortgage backed securities (they do not carry any kind of credit risk protection by the Government Sponsored Enterprises). Investors in search of higher yields kept increasing their demand 31 .25 0 −. 8 Concluding Remarks The subprime mortgage market experienced explosive growth between 2001 and 2006. declined between 2001 to 2007. on a per-unit-of-risk basis. a dummy variable that equals one if a borrower is an investor. In Figure 7 we plot the prediction error. Therefore. the subprime-prime mortgage spread decreased even more than the level of the spread. Angell and Rowley (2006) and Kiff and Mills (2007). and thus the (adjusted) riskiness of loans rose. and the loan-to-value ratio based on a second. among others.5 2001 2002 2003 2004 Year 2005 Prediction Error (%) Fitted Trend 2006 2007 The downward trend in Figure 7 indicates that the subprime-prime spread.

and macroeconomic conditions (such as house price appreciation. the quality of the market deteriorated dramatically. Were problems in the subprime mortgage market apparent before the actual crisis erupted in 2007? A more detailed discussion. 30 32 . for example. and empirical evidence on such episodes is available in Dell’Ariccia and Marquez (2006). Sweden. For the rapid growth of the subprime mortgage market to have been sustainable. In this paper we show that during the dramatic growth of the subprime (securitized) mortgage market. and the subprime mortgage market crashed in 2007. a level of indebtedness. loan characteristics (such as a product type. high-LTV borrowers became increasingly risky (their adjusted performance worsened more) compared to low-LTV borrowers. theory.for private-label mortgage-backed securities. the increase in the overall riskiness of subprime loans should have been accompanied by an increase in the subprime mark-up. In 2001. Over time. The decline in loan quality was monotonic. and Landerretche (2001). Indonesia. an ability to provide documentation). the subprime-prime mortgage rate spread (subprime mark-up) should account for the default risk of subprime loans. among many others. Chile in 1982. Demirg¨c-Kunt and Detragiache (2002). In many respects.30 Argentina in 1980. deteriorating loan performance. In this paper we show that this was not the case: The subprime markup—adjusted and not adjusted for changes in differences in borrower and loan characteristics—declined over time. but not equally spread among different types of borrowers. the subprime market experienced a classic lending boom-bust scenario with rapid market growth. albeit in different economic settings. an amortization term. Valdes. adjusted for differences in borrower characteristics (such as the credit score. Gourinchas. a loan amount. and Finland in 1992. Securitizers seem to have been aware of this particular pattern in the relative riskiness of borrowers: We show that over time mortgage rates became more sensitive to the LTV ratio of borrowers. and decreasing risk premiums. and Kamisky and Reinhart u¸ (1999). which also led to sharp increases in the subprime share of the mortgage market (from around 8 percent in 2001 to 20 percent in 2006) and in the securitized share of the subprime mortgage market (from 54 percent in 2001 to 75 percent in 2006). Thailand. and Korea in 1997 all experienced the culmination of a boom-bust scenario. an mortgage interest rate). By 2006. Norway. a borrower with a one standard deviation above-average LTV ratio paid a 10 basis point premium compared to an average LTV borrower. In principal. in contrast. the premium paid by the high LTV borrower was around 30 basis points. level of neighborhood income and change in unemployment). We measure loan quality as the performance of loans. With the benefit of hindsight we now know that indeed this situation was not sustainable. Mexico in 1994. loosening underwriting standards.

Rapid appreciation in housing prices masked the deterioration in the subprime mortgage market and thus the true riskiness of subprime mortgage loans. at least by the end of 2005. the risk in the market became apparent. Loan quality had been worsening for five years in a row at that point. we show that the monotonic degradation of the subprime market was already apparent. Using the data available only at the end of 2005. When housing prices stopped climbing. 33 .Our answer is yes.

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but include contract type dummies in the regression 37 . loan-to-value ratios. and neighborhood median income. The actual foreclosure rate for loans age six months and younger is close to zero. Using foreclosure instead of delinquency as a measure for non-performance. Actual Foreclosure Rate (%) 18 16 14 12 10 8 6 4 2 0 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 Loan Age (Months) 0 3 4 5 4 2 2007 2006 2005 2004 2003 2002 2001 Adjusted Foreclosure Rate (%) 10 8 6 2007 2006 2005 2004 2003 2002 2001 6 7 8 9 10 11 12 13 14 15 16 17 Loan Age (Months) B Adjusted Delinquency Rate for Hybrids and FRMs Separately In this Appendix we show that the continual deterioration of adjusted loan performance over the 2001–2007 period also occurs when estimating a separate proportional odds model for the main contract types. as can be seen from Figure 8. MSA house price appreciation since origination. change in state unemployment rate since origination. The foreclosure rate is defined as the cumulative fraction of loans that were in foreclosure. real-estate owned. real-estate owned. cash-out refinancing dummies. owner-occupation dummies. as a measure of loan performance. Figure 8: Actual and Adjusted Foreclosure Rates The figure shows the age pattern in the actual (left panel) and adjusted (right panel) foreclosure rate for the different vintage years. Foreclosure is defined as a loan being in foreclosure. The change for each year is statistically significant at the 1% confidence level. documentation levels. or in default. the actual foreclosure rates (Figure 8. right panel.A Foreclosure Rates In this Appendix we show the continual deterioration of adjusted loan performance using foreclosure. 2006. or defaulted. The adjusted foreclosure rate is obtained by adjusting the actual rate for year-by-year variation in FICO scores. The adjusted foreclosure rates of vintage 2001 loans are between vintages 2002 and 2003. mortgage rates. the adjusted foreclosure rates every vintage year starting in2002. In Figure 8 we present actual (left panel) and adjusted (right panel) foreclosure rates. debt-to-income ratios. at or before a given age. instead of delinquency. as opposed to the baseline case in the main text where we perform a single estimation for all loans together. origination amounts. missing debt-to-income ratio dummies. Similar to the actual delinquency rates (Figure 1 (left panel). percentage of loans with prepayment penalties. and 2001 and lowest for 2003 and 2004. composition of mortgage contract types. left panel) are highest for 2007. For older aged loans the actual foreclosure rate is roughly speaking twice as low as the actual delinquency rate. in contrast to the actual delinquency rate at this age (presented in Figure 1 (left panel)). margins.

where the βs are the regression coefficients and X is the first-lien LTV ratio at which the marginal effect is evaluated. Figure 9 shows the adjusted delinquency rate for the two main contract types: 2/28 hybrids and FRMs. and neighborhood median income. the age pattern for the different vintage years looks very much the same for the two contract types. as independent variables.specification. The delinquency rate is defined as the cumulative fraction of loans that were past due 60 or more days. MSA house price appreciation since origination. missing debt-to-income ratio dummies. debt-to-income ratios. Figure 9: Adjusted Delinquency Rates for Hybrids and FRMs Separately The figure shows the adjusted delinquency rates based on hybrid mortgages (left panel) and FRMs (right panel) separately. This is what we plotted in Figure 2. or defaulted. The sensitivity is defined as the regression coefficient on the first-lien LTV (scaled by the standard deviation) in a regression with the mortgage rate as dependent variable and the first-lien LTV. mortgage rates. composition of mortgage contract types. the adjusted delinquency rates have increased monotonically over time. The adjusted delinquency rate is obtained by adjusting the actual rate for year-by-year variation in FICO scores. In this appendix we study the robustness of this result to adding the square of the first-lien LTV and the square of the second-lien LTV as independent variables. Without non-linear terms the marginal effect is simply given by the regression coefficient. For both contract types. real-estate owned. percentage of loans with prepayment penalties. cash-out refinancing dummies. owneroccupation dummies. With the quadratic terms. Hybrid Mortgage Loans 30 25 20 15 10 5 5 0 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 Loan Age (Months) 0 3 4 5 6 2007 2006 2005 2004 2003 2002 2001 Fixed−Rate Mortgage Loans 20 2007 2006 2005 2004 2003 2002 2001 15 10 7 8 9 10 11 12 13 14 15 16 17 Loan Age (Months) C Non-Linearity in the Sensitivity of the Mortgage Rate to the LTV In Figure 2 we plotted the sensitivity of the fixed-rate and 2/28 hybrid mortgage rates to the first-lien LTV ratio. In Figure 10 we report the resulting scaled marginal effect of the first-lien LTV for fixed-rate and 2/28 hybrid mortgages evaluated at a first-lien LTV of 80 percent (left panel) and 90 percent (right panel). Except for a level difference. origination amounts. 38 . loan-to-value ratios. change in state unemployment rate since origination. and the other loan and borrower characteristics listed in Section 6. the marginal effect is given by βLT V + 2βLT V 2 X. at or before a given age. in foreclosure. the second-lien LTV. documentation levels. therefore allowing for a non-linear functional form. margins.

the higher the first-lien LTV ratio. in the case without non-linearity. prepayment penalty dummy. 39 . origination amount. and margin as independent variables. The effect is determined using an OLS regression with the interest rate as dependent variable and the FICO score.2 0 2001 FRM 2/28 Hybrid Scaled Marginal Effect of First−Lien LTV = 90% (%) 1. the more sensitive is the mortgage rate to changes in the first-lien LTV.2 1 . second-lien LTV (and the square). In contrast.Figure 10: Sensitivity of Mortgage Rate to First-Lien LTV Ratio Allowing for Non-Linearity The figure shows the scaled marginal effect of the first-lien loan-to-value (LTV) ratio on the mortgage rate for first-lien fixed-rate and 2/28 hybrid mortgages. Comparing the left and right panels in Figure 10. Moreover.4 . as in Figure 2. the marginal effect is rising over time. owner-occupation dummy.8 . first-lien LTV (and the square). missing debt-to-income ratio dummy. The scaled marginal effect increases by 27 basis points over the course of 3 months in 2007 when the model allows for non-linearity.2 0 2001 FRM 2/28 Hybrid 2002 2003 2004 Year 2005 2006 2007 2002 2003 2004 Year 2005 2006 2007 As shown in Figure 10.4 . cash-out refinancing dummy. consistent with the baseline case results presented in Figure 2.8 . debt-to-income ratio. the increase in the scaled marginal effect is only 13 basis points.6 . Scaled Marginal Effect of First−Lien LTV = 80% (%) . we find that there is a statistically and economically significant non-linear effect of the first-lien LTV on the mortgage rate.6 . prepayment term. The largest difference between the results based on specifications with and without non-linearity is observed for 2/28 hybrid mortgages in 2007 at a first-lien LTV of 90 percent (right panel). term of the mortgage. evaluated at a first-lien LTV of 80 percent (left panel) and 90 percent (right panel).

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