A Dynamic Model of Subprime Mortgage Default: Estimation and Policy Implications1

The increase in defaults in the subprime mortgage market is widely held to be one of the causes behind the recent …nancial turmoil. Key issues of policy concern include identifying the main drivers behind the wave of defaults and predicting the e¤ects of various policy instruments designed to mitigate default. To address these questions, we estimate a dynamic structural model of subprime borrowers’default behavior. We propose a simple and intuitive estimation method, and use our model estimates to simulate how borrowers’default behavior would change under various counterfactual scenarios. The counterfactual exercises allow us to quantify the importance of various factors, such as home price declines and loosened underwriting standards, in explaining the recent increase in subprime defaults. Furthermore, we use simulations to assess the e¤ects of principal write-downs and other foreclosure mitigation policies on the behavior of various subsets of borrowers. JEL Classi…cations: C5, G21 1The views expressed are those of the authors and do not necessarily re‡ect the o¢ cial positions of the Federal Reserve System. Correspondence: [email protected]; [email protected]; [email protected]; [email protected].