Andreas Lehnert

Making Sense of the Subprime Crisis

This paper explores the question of whether market participants could have or should have anticipated the large increase in foreclosures that occurred in 2007 and 2008. Most of these foreclosures stemmed from loans originated in 2005 and 2006, leading many to suspect that lenders originated a large volume of extremely risky loans during this period. However, the authors show that while loans originated in this period did carry extra risk factors, particularly increased leverage, underwriting standards alone cannot explain the dramatic rise in foreclosures. Focusing on the role of house prices, the authors ask whether market participants underestimated the likelihood of a fall in house prices or the sensitivity of foreclosures to house prices. The authors show that, given available data, market participants should have been able to understand that a significant fall in prices would cause a large increase in foreclosures although loan-level (as opposed to ownership-level) models would have predicted a smaller rise than actually occurred. Examining analyst reports and other contemporary discussions of the mortgage market to see what market participants thought would happen, the authors find that analysts, on the whole, understood that a fall in prices would have disastrous consequences for the market but assigned a low probability to such an outcome.

Personal Bankruptcy and Credit Market Competition

The effect of credit market competition on borrower default is theoretically ambiguous, because the quantity of credit supplied may rise or fall following an increase in competition. We investigate empirically the relationship between credit market competition, lending to households, and personal bankruptcy rates in the United States. We exploit the exogenous variation in market contestability brought on by banking deregulation at the state level: after deregulation, banks faced the threat of entry into their state markets. We find that deregulation increased competition for borrowers, prompting banks to adopt more sophisticated credit rating technology. In turn, these developments led previously excluded households to enter the credit market. We document that, following deregulation, (1) overall lending increased, (2) loss rates on loans decreased, and (3) bankruptcy rates rose. Further, we find that lending and bankruptcy rates increased more in states with greater actual (rather than potential) entry, and that credit card productivity increased after the removal of entry restrictions. These findings suggest that entrants brought with them enhanced underwriting technology that allowed for credit extension to new borrowers.

Consumption, Debt and Portfolio Choice: Testing the Effect of Bankruptcy Law

Consumer bankruptcy laws, which vary across states and over time, permit debtors to keep assets below a statutory exemption while debts are forgiven. High exemptions distort household portfolio decisions and tempt households to default on debts, but they also provide a crude form of consumption insurance. We combine information on state-level bankruptcy laws with the Consumer Expenditure Survey from 1984-1999. We find that higher exemptions are associated with (1) higher bankruptcy rates, (2) households that are more likely to simultaneously hold low-return liquid assets and owe high-cost unsecured debt, and (3) slightly better insurance for renters and worse insurance for homeowners.

GSEs, Mortgage Rates, and Secondary Market Activities

Fannie Mae and Freddie Mac are government-sponsored enterprises (GSEs) that purchase mortgages and issue mortgage-backed securities (MBS). In addition, the GSEs are active participants in the primary and secondary mortgage markets on behalf of their own portfolios of MBS. Because these portfolios have grown quite large, portfolio purchases as well as MBS issuance are likely to be important forces in the mortgage market. This paper examines the statistical evidence of a connection between GSE actions and the interest rates paid by mortgage borrowers. We find that both portfolio purchases and MBS issuance have negligible effects on mortgage rate spreads and that purchases are not any more effective than securitization at reducing mortgage interest rate spreads. We also examine the 1998 liquidity crisis and find that GSE portfolio purchases did little to affect interest rates paid by borrowers. These results are robust to alternative assumptions about causality and to model specification.

LIQUIDITY CONSTRAINTS AND INCENTIVE CONTRACTS

Are firms and households constrained in the use of a productive input? Theoretical approaches to this question range from exogenously imposed credit allocation rules to endogenous market failures stemming from some sort of limited-commitment or moral-hazard problem. However, when testing for constraints, researchers often simply ask firms or households if they would wish to borrow more at the current interest rate and/or test for suboptimal use of inputs in production functions relative to a full-information, full-commitment benchmark. We demonstrate that if credit is part of a much larger information-constrained (or limited-commitment) incentive scheme, then input use may very well be distorted away from the first-best. Further, households and firms, in certain well-defined circumstances, may, at the true interest rate or opportunity cost of credit, desire to borrow more (or less) than the assigned level of credit. In other, more constrained, contractual regimes, firms and households would say that they do not want to borrow more (or less), but these regimes are decidedly suboptimal, although the magnitude of the loss does depend on parameter values. We conclude with empirical methods that, in principle, could allow researchers armed with enough data to estimate parameters and distinguish regimes. Researchers then could see if firms and households are truly constrained and, if so, what the welfare loss might be.

Asset pooling, credit rationing, and growth

I study the effect of improved financial intermediation on the process of capital accumulation by augmenting a standard model with a general contract space. With the extra contracts, intermediaries endogenously begin using ROSCAs, or Rotating Savings and Credit Associations. These contracts allow poor agents, previously credit rationed, access to credit. As a result, agents work harder and total economy-wide output increases; however, these gains come at the cost of increased inequality. I provide sufficient conditions for the allocations to be Pareto optimal, and for there to be a unique invariant distribution of wealth. I provide an analytic characterization of a simple model and use numerical techniques to study more general models.

Increasing Returns and Optimal Oscillating Labor Supply

Models featuring increasing returns to scale in at least one factor of production have been used to study two separate phenomena: (1) multiplicity of self-fulfilling rational expectations equilibria (i.e. sunspots), and (2) production schedules that optimally feature bunching. We show in a continuous-time model with increasing returns to labor (IRL) that if the economy features multiple competitive equilibria, the optimal path of investment, employment and consumption cannot be constant, or even smoothly-varying. Any macroeconomic policies that shielded the economy from sunspot fluctuations would necessarily not be optimal. We then characterize the optimal allocation (the solution to the planners problem) in a discrete time version of the model. We find that the optimal investment, employment and consumption policies under increasing returns can feature (1) discontinuous jumps, (2) endogenous cycles (with time-varying cycle limits) and (3) stochastic controls (lotteries). Our discrete-time model is very close to that studied by Christiano and Harrison (1999); they, however find that fluctuations are not optimal. We show that this difference is driven by their assumption that production is linear in capital.

Financial Vulnerabilities, Macroeconomic Dynamics, and Monetary Policy

We define a measure to be a financial vulnerability if, in a VAR framework that allows for nonlinearities, an impulse to the measure leads to an economic contraction. We evaluate alternative macrofinancial imbalances as vulnerabilities: nonfinancial sector credit, risk appetite of financial market participants, and the leverage and short-term funding of financial firms. We find that nonfinancial credit is a vulnerability: impulses to the credit-to-GDP gap when it is high leads to a recession. Risk appetite leads to an economic expansion in the near-term, but also higher credit and a recession in later years, suggesting an intertemporal tradeoff. Monetary policy is generally ineffective at slowing the economy once the credit-to-GDP gap is high, suggesting important benefits from avoiding excessive credit growth. Financial sector leverage and short-term funding do not lead directly to contractions and thus are not vulnerabilities by our definition.