Subprime Lending and House Price Volatility

This paper establishes a theoretical and empirical link between the use of aggressive mortgage lending instruments, such as interest only, negative amortization or subprime, mortgages and the underlying house price volatility. Such instruments, which come into existence through innovation or financial deregulation, allow more borrowing than otherwise would occur. Within the context of a theoretical model with borrowing constraints, we demonstrate that the supply of aggressive lending instruments temporarily increase the asset prices in the underlying market because borrowers use these instruments to further leverage their current income. Furthermore, in our model when lenders re-price mortgage instruments following a negative demand shock, we show that the relative use of aggressive lending instruments declines. These two results imply that the availability of aggressive mortgage lending instruments magnifies the real estate cycle and the effects of large negative demand shocks. Using both local and national price index data we empirically confirm the predictions of the model. In particular, we find that neighborhoods and cities that experience a high concentration of aggressive lending instruments at their respective real estate market peaks suffer more severe price declines and a lower supply of aggressive instruments following a negative demand shock. Overall, we find that the fluctuation of supply of aggressive lending instruments increases the volatility of the underlying asset prices over the course of the market cycle.