Subprime Mortgage Default (Kau J. B., Keenan D. C., Lyubimov C., Slawson V. C. Jr.)

Financial Crises Mortgage

Abstract Using data on privately-securitized subprime ARMs (adjustable rate mortgages) originated between 1997 and 2008 and observed between 2000 and 2008, and so covering the start of the subprime crisis, this paper constructs a reduced-form credit risk model of default, and then uses contractual properties of the loans to infer the market’s price of default risk at various times of origination.

Treating the hazard of default as a process rather than a single realization for each period of origination permits the probability of default to be calculated without knowledge of the still unfolding hazard realization, allowing one to adopt the same position as lenders, who also cannot foretell the future. It is empirically determined that a change in the inherent nature of borrowers caused some deterioration in their default behavior, a change which we can first detect by late 2004, but of which, evidence indicates, the secondary mortgage market became aware at about the same time. The large rise in defaults in 2007 cannot, therefore, be attributed to any surprise other than the unexpectedly large fall in housing prices.
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Libref/ Kau J. B., Keenan D. C., Lyubimov C., Slawson V. C. Jr. (2010) “Subprime Mortgage Default”, pp. 1-34
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