Between 2003 and 2006, the composition of the stock of outstanding residential mortgages in the United States changed in several important ways. The fraction of mortgages with variable payments relative to all mortgages increased from 15% to over 25% (see figure 1.) At the same time, the fraction of “subprime” mortgages (mortgages issued to borrowers perceived by lenders to be high-default risks) relative to all mortgages rose from 5% to nearly 15%. Recent work (see e.g. Gerardi et al., forthcoming, figure 3) has shown that many of these subprime loans are characterized by high loan-to-value (LTV) ratios and non-traditional amortization schedules.
Low downpayments and delayed amortization cause payments from the borrowers to the lender to be backloaded compared to standard loans. By lowering payments initially, these features made it possible for more households to obtain the financing necessary to purchase a house. At the same time however, because these contracts are characterized by little accumu-lation of home equity early in the life of the loan, they are prone to default when home prices fall. Not surprisingly then, (see Gerardi et al., 2009) mortgages issued between 2005 and 2006 with high leverage and non-traditional amortization schedules have defaulted at much higher frequency than other loans since home prices began their collapse in late 2006.
Our objective is to quantify the importance of non-traditional mortgages for the recent flare-up in foreclosure rates depicted in figure 1. Specifically, we ask the following question: How much of the rise in foreclosures can be attributed to the increased originations of non traditional mortgages between 2003 and 2006?
To answer this question, we describe a housing model where the importance of non-traditional loans for mortgage default rates can be measured. The model predicts origination rates of non-traditional mortgages between 2003 and 2006 and a spike in foreclosure rates following the collapse in home prices in late 2006 that are both consistent with the relevant evidence. In the context of that model, we find that the popularity of non-traditional mortgages between 2003 and 2006 can account for 40% of the crisis.
