The failure of models that predict failure: Distance, incentives, and defaults
Amit Seru and
Journal of Financial Economics, 2015, vol. 115, issue 2, 237-260
Statistical default models, widely used to assess default risk, fail to account for a change in the relations between different variables resulting from an underlying change in agent behavior. We demonstrate this phenomenon using data on securitized subprime mortgages issued in the period 1997–2006. As the level of securitization increases, lenders have an incentive to originate loans that rate high based on characteristics that are reported to investors, even if other unreported variables imply a lower borrower quality. Consistent with this behavior, we find that over time lenders set interest rates only on the basis of variables that are reported to investors, ignoring other credit-relevant information. As a result, among borrowers with similar reported characteristics, over time the set that receives loans becomes worse along the unreported information dimension. This change in lender behavior alters the data generating process by transforming the mapping from observables to loan defaults. To illustrate this effect, we show that the interest rate on a loan becomes a worse predictor of default as securitization increases. Moreover, a statistical default model estimated in a low securitization period breaks down in a high securitization period in a systematic manner: it underpredicts defaults among borrowers for whom soft information is more valuable. Regulations that rely on such models to assess default risk could, therefore, be undermined by the actions of market participants.
Keywords: Statistical model; Lucas critique; Mortgage default; Regulation (search for similar items in EconPapers)
JEL-codes: G18 G21 G28 (search for similar items in EconPapers)
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (85) Track citations by RSS feed
Downloads: (external link)
Full text for ScienceDirect subscribers only
Working Paper: The Failure of Models That Predict Failure: Distance, Incentives, and Defaults (2015)
This item may be available elsewhere in EconPapers: Search for items with the same title.
Export reference: BibTeX
RIS (EndNote, ProCite, RefMan)
Persistent link: https://EconPapers.repec.org/RePEc:eee:jfinec:v:115:y:2015:i:2:p:237-260
Access Statistics for this article
Journal of Financial Economics is currently edited by G. William Schwert
More articles in Journal of Financial Economics from Elsevier
Bibliographic data for series maintained by Catherine Liu ().