Deconstructing a Mortgage Meltdown : A Methodology for Decomposing Underwriting Quality

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 observable credit standards is not monotonic. While the easing of important risk characteristics, like loan to value ratios, in the early 1990s was arguably deliberate, the negative effects of lower standards was masked by strong local and national economic conditions. 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 the latter 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 mortgages, particularly subprime and Alt-A loans, caused underwriting risks to be mispriced