Understanding the Subprime Mortgage Crisis
Yuliya Demyanyk, Otto Van Hemert∗ This Draft: December 5, 2008 First Draft: October 9, 2007

Abstract Using loan-level data, we analyze the quality of subprime mortgage loans by adjusting their performance for differences in borrower characteristics, loan characteristics, and macroeconomic conditions. We find that the quality of loans deteriorated for six consecutive years before the crisis and that securitizers were, to some extent, aware of it. We provide evidence that the rise and fall of the subprime mortgage market follows a classic lending boom-bust scenario, in which unsustainable growth leads to the collapse of the market. Problems could have been detected long before the crisis, but they were masked by high house price appreciation between 2003 and 2005.

∗ Demyanyk: Banking Supervision and Regulation, Federal Reserve Bank of St. Louis, P.O. Box 442, St. Louis, MO 63166, Yuliya.Demyanyk@stls.frb.org. Van Hemert: Department of Finance, Stern School of Business, New York University, 44 W. 4th Street, New York, NY 10012, ovanheme@stern.nyu.edu. The authors would like to thank Cliff Asness, Joost Driessen, William Emmons, Emre Ergungor, Scott Frame, Xavier Gabaix, Dwight Jaffee, Ralph Koijen, Andreas Lehnert, Andrew Leventis, Chris Mayer, Andrew Meyer, Toby Moskowitz, Lasse Pedersen, Robert Rasche, Matt Richardson, Stefano Risa, Bent Sorensen, Matthew Spiegel, Stijn Van Nieuwerburgh, James Vickery, Jeff Wurgler, anonymous referees, and seminar participants at the Federal Reserve Bank of St. Louis; the Florida Atlantic University; the International Monetary Fund; the second New York Fed—Princeton liquidity conference; Lehman Brothers; the Baruch-Columbia-Stern real estate conference; NYU Stern Research Day; Capula Investment Management; AQR Capital Management,; the Conference on the Subprime Crisis and Economic Outlook in 2008 at Lehman Brothers; Freddie Mac; Federal Deposit and Insurance Corporation (FDIC); U.S.