Tuesday, November 20, 2007


Subprime Mortgages. "The Rise and Fall of Subprime Mortgages" by Danielle DiMartino and John Duca is a good Dallas Fed discussion of the subprime mortgage crash. They explain it as the result of overly bold financial innovation. People didn't realize how liable to default subprime mortgages were, which meant that the innovation used to securitize them was unreliable. What as done was to divide a package of mortgages into tranches, bundles with different amounts of the risk allocated to them, where the packaging was supposed to put almost all the default risk into the lowest tranches so the upper ones could be AA quality. The problem is that if the amount of default is higher than the entire value of the lower tranches, default creeps into the upper ones.

They also have a good explanation for overconfidence:

Subprime loan problems had surfaced just before and at the start of the 2001 recession but then rapidly retreated from 2002 to 2005 as the economy recovered (Chart 3). This pre-2006 pattern suggested that as long as unemployment remained low, so, too, would default and delinquency rates.

This interpretation ignored two other factors that had helped alleviate subprime loan problems earlier in the decade. First, this was a period of rapidly escalating home prices. Subprime borrowers who encountered financial problems could either borrow against their equity to make house payments or sell their homes to settle their debts. Second, interest rates declined significantly in the early 2000s. This helped lower the base rate to which adjustable mortgage rates were indexed, thereby limiting the increase when initial, teaser rates ended.


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