Mortgage Crisis

Question 1

What are the three key facts of the US mortgage crisis?

Answer 1

1. Growth in mortgage credit, mostly to subprime borrowers
2. Increase in securitization of subprime mortgages
3. Growth in defaults for subprime borrowers

Question 2

According to Mian & Sufi, what are three competing explanations for the expansion of subprime mortgages?

Answer 2

1. Income-based hypothesis –> expansion was driven by better income prospects
2. Supply-based hypothesis –> expansion was driven by outward shift in supply of credit by lenders
3. House price expectation-based hypothesis –> expansion was driven by lenders’ increased expectations of the housing prices

Question 3

How do we define a subprime borrower?

Answer 3

Consumer with a FICO credit score below 660.

Question 4

What is a FICO credit score?

Answer 4

Credit rating by the analytics company FICO based on payment history, debt burden, length of credit history etc.

Question 5

Who is the FHA and what do they do?

Answer 5

Federal Housing Administration
They provide mortgage loan insurance.

Question 6

How does the fraction of subprime borrowers relate to income and credit growth?

Answer 6

Higher fraction of subprime borrowers leads to lower income.
Higher fraction of subprime borrowers leads to higher credit growth.

Question 7

When comparing subprime to prime borrowers on growth rates and loan amounts, what can we see?

Answer 7

Growth rate of credit to subprime borrowers grew harder than for prime borrowers.
Amount of credit to subprime borrowers grew harder than for prime borrowers.

Question 8

What was the result of the income-based hypothesis and does this explain the sharp increase in mortgage defaults?

Answer 8

Negative correlation between credit growth and income growth (for the first time in 18 years). This likely explains the sharp increase in mortgage defaults.

Question 9

Perhaps, the increase in subprime mortgages was due to certain business cycle conditions. How can we measure that and what was the result?

Answer 9

Compare the subprime mortgage increase to another post-recession period. Stronger growth for the 2002-2005 period.

Question 10

What does the supply-based hypothesis predict?

Answer 10

Can the growth in subprime mortgage credit be explained by a shift in credit supply?

Question 11

How to check the supply-based hypothesis and what are its results?

Answer 11

Check the denial rate of mortgages
Check the securitization of subprime mortgages.
Check who they sold the MBS to.

The denial rate declined which means that more mortgages got accepted, which is in line with SBH.
Subprime mortgages where more securitized in that period, which is in line with SBH.
MBS were sold to securitized pools and noncommercial banks and not to commercial banks and affiliated investors.

Question 12

Why were the mortgage-backed securities not sold to affiliated investors and commercial banks?

Answer 12

Because they had the ability to screen the investment and know it was a bad investment.

Question 13

Was there an increase in housing prices before the crisis?

Answer 13

Yes

Question 14

To check if the house expectation hypothesis holds, we should distinguish between two scenarios. Which ones?

Answer 14

Inelastic and elastic housing supply areas

Question 15

What happens to an inelastic housing supply area when there is upward housing price pressure?

Answer 15

No new houses are built and the prices therefore increase

Question 16

What happens to an elastic housing supply area when there is upward housing price pressure?

Answer 16

New houses are built and the prices remain constant because the demand it matched with supply

Question 17

How do we relate the result of elastic housing supply areas to the house expectation hypothesis?

Answer 17

The elastic housing supply area keeps the prices constant because new houses are being built and this is not in line with house expectation hypothesis who states that housing prices increase.

Question 18

Next to constant housing prices, what is another argument against the house expectation hypothesis?

Answer 18

If house price expectation hypothesis drives credit expansion, then in elastic housing supply areas, there should be no change in subprime mortgage credit growth, but there is!

Question 19

What is likely to explain the growth in housing prices?

Answer 19

Expansion of subprime mortgages driven by securitization.

Question 20

Describe how higher housing prices can create even higher housing prices through credit.

Answer 20

House price goes up, collateral goes up, credit availability goes up, house price goes up again.

Question 21

Describe lenders’ moral hazard in the light of securitization of subprime mortgages.

Answer 21

Incentives are not aligned. Lenders have no incentive to carefully screen loans they sell to investors.

Question 22

What is securitization?

Answer 22

Securitization converts illiquid assets into liquid securities.

Question 23

Name two benefits of securitization.

Answer 23

Improving risk sharing through MBS.
Reducing banks’ cost of capital.