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The impact of credit risk mispricing on mortgage lending during the subprime boom

James A Kahn and Benjamin S Kay

No 875, BIS Working Papers from Bank for International Settlements

Abstract: We provide new evidence that credit supply shifts contributed to the U.S. subprime mortgage boom and bust. We collect original data on both government and private mortgage insurance premiums from 1999-2016, and document that prior to 2008, premiums did not vary across loans with widely different observable characteristics that we show were predictors of default risk. Then, using a set of post-crisis insurance premiums to fit a model of default behavior, and allowing for time-varying expectations about house price appreciation, we quantify the mispricing of default risk in premiums prior to 2008. We show that the flat premium structure, which necessarily resulted in safer mortgages cross-subsidizing riskier ones, produced substantial adverse selection. Government insurance maintained a flatter premium structure even post-crisis, and consequently also suffered from adverse selection. But after 2008 the government reduced its exposure to default risk through a combination of higher premiums and rationing at the extensive margin.

Keywords: financial crisis; mortgage insurance; housing finance; default risk (search for similar items in EconPapers)
JEL-codes: G21 E44 E32 (search for similar items in EconPapers)
Pages: 66 pages
Date: 2020-08
New Economics Papers: this item is included in nep-ban, nep-ias, nep-mac and nep-ure
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