Is Everything we "Know" about Subprime Wrong?

Yesterday I saw a great talk by Paul Willen of the Boston Fed. An earlier version of the paper he gave is here.

I don't think I am caricaturing what he said to say when I describe the following takeaways from his talk:

(1) Falling house prices lead to defaults more than defaults lead to falling house prices. In the early
part of the decade, when delinquencies reached record levels, default rates remained extremely low, because house prices were rising (see his graph on Page 48).

(2) Interest rate resets have little if anything to do with the large number of defaults we are observing. For the vast majority of subprime loans, defaults or refinances happen before resets take place. It is moreover the case that the size of the resets is smaller than most of us think, because the initial teaser rates are pretty high.

(3) While ARMs have higher default rates than FRMs, putting ARM borrowers into FRMs will not necessarily reduce defaults. In the first place, as people move out of ARMs into FRMs, the denominator in the default proportion ratio will decline for ARMs, while increasing for FRMs, meaning that if the number defaults stay constant, the default share in ARMs will still rise.

Beyond this last point, a working paper I have with Cutts and Ramogopal shows that ARM borrower are fundamentally more likely to be risk-takers than FRM borrowers, so the difference in loan performance between the two products may say more about the distributions of the different borrowers, rather than the products themselves.

In any case, all of this means that many of the policies being pushed at the moment (such as interest rate freezes) may not be particularly helpful in resolving the crisis.