The subprime mortgage crisis has done more damage to the financial system than any financial crisis since the depression. This paper examines the Federal Reserve’s expansionary monetary policy during the early part of this decade, the effect of that expansionary policy on mortgage market liquidity, the effects of that liquidity on housing price movements, and the way that those price movements contributed to the severity of the financial crisis. House prices increased most in the low-priced tier of the market during the expansion, which prompted lenders and investors in mortgage-backed securities to finance highly leveraged purchases in this segment of the market. But house prices also decline most in the low-priced tier during a contraction or collapse, among borrowers with inadequate assets and income to absorb the decline in their home values if forced to sell their homes. Consequently, their losses were transmitted into the financial sector, with an impact far more devastating than in any crisis since the depression. In order to address this structural vulnerability of the residential real estate market, several problems with incentives and information disclosure at almost every stage in the lending and securitization process need to be addressed, including the incentives of home buyers, loan originators, loan servicers, bond rating firms, investment banks, and credit enhancement providers. Alternatively, many of the problems with risk assessment may need to be transferred to investors, who have a clear incentive to gather information and assess risks, and can discipline lenders by directing capital to those lenders who adequately manage lending risks.
Gjerstad, S. (2009). Housing market price tier movements in an expansion and collapse. ESI Working Paper 09-01. Retrieved from http://digitalcommons.chapman.edu/esi_working_papers/141