The failure of models that predict failure: Distance, incentives, and defaults

Uday Rajan, Amit Seru and Vikrant Vig

Journal of Financial Economics, 2015, vol. 115, issue 2, 237-260

Abstract: 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)
Date: 2015
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (117)

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Working Paper: The Failure of Models That Predict Failure: Distance, Incentives, and Defaults (2015)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:jfinec:v:115:y:2015:i:2:p:237-260

DOI: 10.1016/j.jfineco.2014.09.012

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