The Subprime Mortgage Crisis: Irrational Exuberance or Rational Error?

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The Subprime Mortgage Crisis Irrational
Exuberance or Rational Error?

• Nick Kojucharov, Robert F. Martin,
• Clyde F. Martin, and Lili Xu

January 2, 2009
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Overview

• The Subprime Market
• Key question Why did investors purchase
  subprime mortgages? Why did market collapse?
• Model
• Disagreement over risk in subprime assets
• Replicate data on both defaults and prepayments
• Policy Evaluation
• What can the model tell us about effectiveness
• of policy intervention?

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Defaults and Prepayments

• Any robust model must handle both default and
  prepayment behavior
• Close to 100 of mortgages dead at 60 months
• Match origination volume and changes in subprime
  spreads
• We will do this through investor beliefs about
  risk

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Two Types of Agents

• Investors
• Purchase portfolios of subprime mortgages,
  equities, and bonds
• Know all model parameters except the level of
  aggregate risk in subprime mortgages
• Bayesian learners
• Update their beliefs by comparing default and
  prepayment data to their priors
• Every observation is informative

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Two Types of Agents

• Households
• All homeowners hold a mortgage
• Default
• Early Payoff (prepayment) move to rental or
  refinance
• Optimal stopping problem
• Problem is characterized by random variable
  (function of state) moving between two
  boundaries.

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Mortgages as a Dividend Process
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Mortgages as a Dividend Process
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Model Behavior
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Calibration Matching 2003 and 2004
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Calibration Matching 2003 and 2004
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Learning ?

• Investors know ? is either high or low but not
  its value.

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Simulation Matching 2006

• Probability of drawing 2006 outcome under 2003
  calibration.

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Simulations

• Change the variance and the mean of the aggregate
  shock to have 2006 be the mean outcome.

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Credit Deterioration Alone
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Policy Alternatives

• Many different policies are on the table for
  fixing the subprime crisis.
• We can use our model to evaluate the
  effectiveness of different policies.

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Foreclosure Moratorium

• A five-year moratorium on foreclosures.
• Mapping moratorium into the model
• Households entering default region stay in house
  without penalty make no payments.
• Remove default boundary increase upward drift
  on all households near boundary
• Replace default boundary 5 years later all
  households above boundary default immediately.

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Foreclosure Moratorium
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Takeaways

• Rational mis-estimation as opposed to irrational
  exuberance
• Subprime market is dead
• Homeownership rates artificially inflated, now
  down to earlier levels
• Price adjustments may be very large (Mian and
  Sufi (2008))