ABSTRACTS OF PAPERS BY ROSS FINANCE FACULTY
16^th Mitsui Finance Symposium,  June 2009

Title: Deconstructing a Mortgage Meltdown: A Methodology for Decomposing Underwriting Quality

Authors: Charles D. Anderson (University Financial  Associates LLC), Dennis R. Capozza (Michigan), and Robert Van Order (Michigan)

Abstract: Technical progress in originating and pricing mortgages has enabled a trend since 1979 toward more relaxed credit standards on mortgage lending, which is reflected in rising foreclosure rates.  We develop a methodology for decomposing the trend in mortgage performance in the national serviced portfolio into a part due to economic conditions and a part due to underwriting changes. The decomposition provides natural metrics or indices of underwriting quality and economic conditions. The results suggest that the recent mortgage debacle can be attributed about equally to each factor.

The relaxation in credit standards bifurcates after 1990 into two periods. In the first, during the 1990s, there was a deliberate lowering of observable credit standards, like loan to value ratios.  During this period the negative effects of lower standards was masked by strong local and national economic conditions. . In the second period, after 2000, there was little change in observable loan characteristics; nevertheless, loan performance continued to erode even after controlling for the economic environment.  We present evidence that the erosion in this second period must have arisen from underwriting covariates that are typically unobservable to investors in securitizations.  This evidence is consistent with the hypothesis that moral hazard in “non-agency” securitizations of subprime and Alt-A loans caused underwriting risks to be mispriced in securitizations.

TITLE: Costly External Finance, Corporate Investment, and the Subprime Mortgage Credit Crisis

Authors: Ran Duchin (Michigan), Oguzhan Ozbas (University of Southern California), and Berk A. Sensoy (University of Southern California)

 Abstract: We study corporate investment in the wake of the subprime mortgage credit crisis that began in summer 2007. The crisis represents an unexplored negative shock to the supply of credit for nonfinancial firms. We find that corporate investment declines significantly following the onset of the crisis. The decline is greatest for firms that have low cash reserves (or high net debt) or are financially constrained, i.e. more likely to face difficulties raising external capital. These results are robust to controls for industry- and firm-specific investment opportunities. We also find that “excess” cash, as defined by previous work, is positively related to post-crisis investment, suggesting an important precautionary savings role for seemingly excess cash that has not been emphasized in the literature. Overall, our results suggest that an important channel for the effects of the subprime crisis on the real economy is a tightened supply of credit for non-financial firms.

TITLE: On the Price Comovement of U.S. Residential Real Estate Markets

Authors: Jarl Kallberg (Thunderbird School of International Management), Crocker H. Liu (Arizona State University), and Paolo Pasquariello (Michigan)

Abstract: This study addresses the recent performance of the U.S. residential real estate markets. We investigate the comovement among Case-Shiller Home Price Indices for 14 metropolitan areas between 1992 and 2008. We identify the portion of this comovement deemed as fundamental (excessive), which we define as the covariation that can (cannot) be attributed to common fundamental factors directly influencing real estate prices. We find that the degree of comovement in these markets increased over the sample period, most significantly so in the late 1990s, but that this increase is largely due to systematic sources of risk; the degree of excess comovement is a less important factor. Further analysis indicates that the dynamics of comovement among metropolitan U.S. residential real estate markets within the sample period are mostly attributable to underlying systematic real and financial factors, consistent with a greater fundamental integration of those markets. We discuss the implications of these results for the evolution of U.S. real estate prices over the last two decades and the ongoing credit crisis.

Title: The Failure of Models That Predict Failure: Distance, Incentives and Defaults

Authors:  Uday Rajan (Michigan), Amit Seru (University of Chicago) and Vikrant Vig (London School of Business)

Abstract: Using data on securitized subprime mortgages issued in the period 1997--2006, we demonstrate that, as the degree of securitization increases, interest rates on new loans rely increasingly on hard information about borrowers. As a result, a statistical default model fitted in a low securitization period breaks down in the high securitization period in a systematic manner: it underpredicts defaults among borrowers for whom soft information is more valuable (i.e., borrowers with low documentation, low FICO scores and high loan-to-value ratios). We rationalize these findings in a theoretical model that highlights a reduction in lenders' incentives to collect soft information as securitization becomes common, resulting in worse loans being issued to borrowers with similar hard information characteristics. Our results partly explain why statistical default models severely underestimated defaults during the subprime mortgage crisis, and imply that these models are subject to a Lucas critique. Regulations that rely on such models to assess default risk may therefore be undermined by the actions of market participants.