The subprime mortgage crisis: irrational exuberance or rational error?

Kojucharov, Nikola; Martin, Clyde F.; Martin, Robert F.; Xu, Lili

Conference Paper

The subprime mortgage crisis: irrational exuberance or rational error?

Abstract: We present a model of the subprime market in which credit quality and loan performance are driven by a statistical process with idiosyncratic and aggregate shocks. Investors use portfolio performance to infer the weight of each shock. We show that low and stable default rates from 2002-2005 convinced investors that the aggregate shock weight was small. In late 2006, when default rates surged, the market collapsed abruptly as investors abandoned their low-weight beliefs. We examine various proposals to fix the mortgage market and find that policy intervention has limited effectiveness in our model.

Keywords: Subprime mortgage;

Status: Published in “Day ahead" conference on financial markets (2009 : January 2)