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Around the Fed: Lending standards and the foreclosure crisis

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Lending Standards and the Foreclosure Crisis “Decomposing the Foreclosure Crisis: House Price Depreciation versus Bad Underwriting.” Kristopher Gerardi, Adam Hale Shapiro, and Paul S. Willen, Federal Reserve Bank of Atlanta Working Paper 2009-25, September 2009. There are two competing theories to explain the suddenoutbreak of foreclosures from 2007 to 2009. One theory centers on poor underwriting standards: Borrowers had trouble making payments on their mortgages because those loans were either unrealistically generous or because borrowers were taking out loans based on little income and bad credit. An alternative explanation suggests that housing values were the main explanatory variable in the growth of foreclosures. After all, the authors point out, subprime mortgage performed well until 2006 when house prices began falling. Using deeds records from Massachusetts — including residential mortgages, purchase and sale, and foreclosure transaction between 1989 and 2008 — the authors create a model to describe the explosion of foreclosures in Massachusetts since 2005. To isolate the effects of the underwriting standards, they estimated what the foreclosure rate of subprime borrowers in 2005 would have been if the price of the homes purchased were in line with the 2002 pricing levels. They discovered that the foreclosure rate would have been vastly lower relative to the actual observed foreclosure rate despite the larger percentage of subprime borrowers that existed in 2005. The authors conclude that “relaxed underwriting stan- dards did severely aggravate the crisis by creating a class of homeowners who were particularly vulnerable to the decline in prices.” Yet, “that emergence alone, in the absence of a price collapse, would not have resulted in the substantial foreclosure boom that was experienced.” “Vacancy Posting, Job Separation, and Unemployment Fluctuations.” Regis Barnichon, Federal Reserve Board Finance and Economics Discussion Series 2009-35, July 2009. In this p

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