On Modeling Some Essential Dynamics of the Subprime Mortgage Crisis

We develop a Systems Dynamics model for capturing the key interactions involved in the evolution of the subprime mortgage crisis. In particular, we propose an aggregate modeling resolution that involves three main sub-systems, namely, an aggregate banking system, an aggregate housing market and an economic environment. The model exposes the physics of each individual system as well as influences and interactions among the three systems. The model is useful for developing intuition about the evolution of the crisis as well as the lagged timing and magnitude of the effects of various corrective actions, such as an economic stimulus package. We present three scenarios using simulated data. In the first scenario, we establish an equilibrium state that represents a steady state normal condition. In the second scenario, we introduce a step function for the availability of subprime loans and hold it for certain duration. This practice eventually culminates in a credit crisis, where the aggregate bank experiences insolvency. In the third scenario, we study the application of an economic stimulus, which steers the entire system back to a new equilibrium state. We note that the economic stimulus needs to be larger than a certain critical lower threshold in order to enable the system towards reaching a new equilibrium.