and seminar participants at Duke (Fuqua School of Business) and London Business School for useful discussions. The opinions expressed in the paper are those of the authors and do not reflect the views of Sorin Capital Management. All remaining errors are our responsibility.

research assistance and especially Andreas Lehnert and Tomek Piskorski for helpful comments. The views and conclusions expressed herein do not necessarily reflect the views of the Board of Governors of the Federal Reserve System, its members, or its staff. The mortgage market began suffering serious problems in mid-2005. According to data from the Mortgage Bankers Association, the share of mortgage loans that were “seriously delinquent ” (90 days or more past due or in the process of foreclosure) averaged 1.7 percent from 1979 to 2006, with a low of about 0.7 percent (in 1979) and a high of about 2.4 percent (in 2002). But by the second quarter of 2008, the share of seriously delinquent mortgages had surged to 4.5 percent. These delinquencies foreshadowed a sharp rise in foreclosures: roughly 1.2 million foreclosures were started in the first half of 2008, an increase of 79 percent from the 650,000 in the first half of 2007 (Federal Reserve estimates based on data from the Mortgage Bankers Association). No precise national data exist on what share of foreclosures that start are actually completed, but anecdotal evidence suggests that historically the proportion has been somewhat less than half (Cordell, Dynan, Lehnert, Liang, Mauskopf, 2008). Mortgage defaults and delinquencies are particularly concentrated among borrowers whose mortgages are classified as “subprime ” or “near-prime. ” Some key players in the

of Australia, and the Australian Prudential Regulatory Authority for valuable comments. Yian Liu provided

ABSTRACT. A popular explanation for the recent rise in mortgage default is that securitization led to lender moral hazard. According to the story, lending banks that could easily resell loans to (possibly naive) securitizers had little incentive to carefully screen potential borrowers. Some research has supported this view by exploiting what appear to be credit score cutoff rules used by securitizers. In this paper we argue that the cutoff rule evidence has been misinterpreted and is in fact consistent with an equilibrium model where all actors are rational and lender moral hazard is avoided. Even without securitization, cutoff rules emerge endogenously as a rational response of lenders to perapplicant fixed costs in screening. Securitizers ’ response to lender cutoff rules is determined by the degree of information asymmetry between lender and securitizer. Both institutional evidence and findings from a loan-level dataset containing nearly 60 % of active residential mortgages in the United States appear consistent with our model. Discontinuous jumps in mortgage volume and default rate at the FICO credit score of 620 are apparent, implying a change in lender screening behavior at the threshold, but in our main sample of conforming loans there is no corresponding jump in the securitization rate at this score.

A drop in aggregate demand driven by shocks to household balance sheets is responsible for a large fraction of the decline in U.S. employment from 2007 to 2009. The aggregate demand channel for unemployment predicts that employment losses in the non-tradable sector are higher in high leverage U.S. counties that were most severely impacted by the balance sheet shock, while losses in the tradable sector are distributed uniformly across all counties. We find exactly this pattern from 2007 to 2009. Alternative hypotheses for job losses based on uncertainty shocks or structural unemployment related to construction do not explain our results. Using the relation between non-tradable sector job losses and demand shocks and assuming Cobb-Douglas preferences over tradable and non-tradable goods, we quantify the effect of aggregate demand channel on total employment. Our estimates suggest that the decline in aggregate demand driven by household balance sheet shocks accounts for almost 4 million of the lost jobs from 2007 to 2009, or 65 % of the lost jobs in our data.

1 The authors thank a major national mortgage bank for providing the data and assistance in data processing and the

This paper explains the products that were used to securitize mortgages during the period leading up to the credit crunch of 2007 and explains why many of these products have performed so badly. It also examines some of the lessons that can be learned from the crisis.

The exact cause of the massive defaults and foreclosures in the U.S. subprime mortgage market is still unclear. This paper investigates whether a particular aspect of borrowers ’ financial literacy, their numerical ability, may have played a role. We measure several aspects of financial literacy and cognitive ability in a survey of subprime mortgage borrowers who took out mortgages in 2006 and 2007, and match these measures to objective data on mortgage characteristics and repayment performance. We find a large and statistically significant negative correlation between numerical ability and various measures of delinquency and default. Foreclosure starts are approximately two-thirds lower in the group with the highest measured level of numerical ability compared to the group with the lowest measured level. The result is robust to controlling for a broad set of socio-demographic variables and is not driven by other aspects of cognitive ability, or the characteristics of the mortgage contracts. Our results raise the possibility that limitations in certain aspects of financial literacy played an important role in the subprime mortgage crisis.

We analyze the structure and attributes of subprime mortgage-backed securitization deals originated between 1997-2007. Our unique data set allows us to map loan-level data for over 7 million subprime loans to the securitization deals into which the loans were sold. We document the relationship between the structure of the securitization deal and the attributes of the underlying mortgage collateral, including housing market conditions at the time of deal origination. We find evidence in support of the hypothesis that deals with higher levels of housing market diversification have a larger portion of the deal rated investment grade. Additionally, we find that deals comprised of loans concentrated in areas with high rates of home price appreciation have a larger portion of the deal rated investment grade. We believe these results highlight how the structure of securitization deals could impact the supply of credit being afforded the mortgage origination market. Deal structure matters because the economics of the structuring process create incentives for deal arrangers to purchase loans that will provide the cheapest funding for the deal.

In a sample covering more than 300 cities in the US between January 2000 and July 2009, we find that more restrictive residential land use regulations and geographic land constraints are linked to larger booms and busts in housing prices. The natural and man-made constraints also amplify price responses to an initial positive mortgage-credit supply shock, leading to greater price increases in the boom and subsequently bigger losses. JEL classification: R3