More facts.

* Regional banks were holding Fannie and Freddie securities—and those securities were counted as ‘safe’ by the regulators, who, in fact, encouraged the regional banks to hold Fannie and Freddie securities.

* SSRN-The Consequences of Mortgage Credit Expansion: Evidence from the 2007 Mortgage Default Crisis by Atif Mian, Amir Sufi

We show that an expansion in the supply of mortgage credit to high latent demand zip codes led to the rapid increase in house prices from 2001 to 2005 and subsequent defaults from 2005 to 2007. From 2001 to 2005, high latent (unfulfilled) demand zip codes experience relative declines in denial rates and interest rates and relative increases in mortgage credit and house prices, despite the fact that these zip codes experience negative relative income and employment growth. The growth in securitization was significantly higher in high latent demand zip codes, suggesting a possible role of securitization in credit expansion.

High latent demand zip codes are zip codes that had trouble getting credit in 1996.

This issue is not extending credit–a good thing if the loan is priced correctly, and the lender is happy to take the risk–but instead the issue is how well the lenders able to predict defaults for those loans. The predictions broke down. Did the lenders (holders of the securitized loans) know how much risk they were taking?

* The Bankruptcy Reform Act of 2005 made is harder to default on credit cards than before. That legislation was passed in 2005. Did the default prediction models consider how the change in bankruptcy rules would change borrower’s incentives to default? Now borrowers have incentive  default on the house before they default on your credit cards. A new regime. But securitizers used a sample from the old regime to estimate defaults….

And the securities’ exposure to default risk—the model risk—was magnified by the releveraging CDOs, etc.

Fitting ‘data’ with models is useless unless you have some compelling structural interpretation for the results.

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