lending distributed no uniformly over space, they were able

instruments and underlying asset market prices. Industry sources suggest that
aggressive lending instruments, such as interest-only loans,
negative-amortization loans, low- or zero-equity loans and teaser-rate
adjustable-rate mortgages (ARMs), accounted for nearly two-thirds of all U.S.
loan originations since 2003. They demonstrated theoretically
that the introduction of aggressive lending instruments increases asset prices
in the underlying market because agents find it more attractive to switch from
renting to owning and take advantage of the low-cost financing and/or because
they find their credit constraint relaxed. Aggressive instruments, which come
into existence through innovation or financial deregulation, allow more
borrowing than otherwise would occur. The greater initial affordability of
aggressive instruments relative to traditional mortgages implies that these
instruments will be in higher demand in less-affordable markets. The lending
sector acquired this new ability to offer aggressive products through financial
innovation and deregulation. In particular, risk-based pricing became possible
through the implementation of automated underwriting models, and lending for
riskier mortgages became widespread in the late 1990s with the development of
private label securitization of nonconforming loans. At the same time,
deregulation allowed banks to originate and securitize these mortgages without
recourse, that is, without having to account for the buyback provisions
embedded in these securities. This additional source of funding at the borrower
level increases demand for housing that is then translated into higher market
prices, with the effect greatest in markets of fixed or inelastic supply. Because
aggressive mortgage instruments are distributed no uniformly over space, they were able to test
for the impact they have on property markets. They used
cross-sectional data to compare outcomes across regions with different
concentrations of aggressive mortgage instruments to test for the implications
of the model. They were further able
to test for the mechanism of the model by linking the market share of
aggressive mortgages to price dynamics over time and through the use of two
separate instrumental variables.

They used county-level
origination data to empirically investigate the hypothesized links. They found that areas
with high concentrations of aggressive lending instruments experience larger
price run-ups during rising markets and deeper crashes during down markets.
This basic finding holds even when they controlled for the
contemporaneous changes in household income, use lead–lag relationships and use
two separate instrumental variables: affordability and share of minority
households. Both of these instrumental variables are highly correlated with the
use of subprime instruments but are uncorrelated with future price changes in
the market. Yet, the subprime share of originations predicted by each of these
two instruments is highly significant and explains a great deal of the
cross-sectional variation of real estate market price changes.

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