Abstract
Was the mortgage boom fueled by optimism around house prices, or did misaligned incentives in the mortgage industry also play a role? In this paper, we provide novel evidence of a role for misaligned incentives. We document that private mortgage insurance (PMI) companies dramatically expanded insurance issuance on high-risk mortgages purchased by Fannie Mae and Freddie Mac at the tail-end of the housing boom, without changing pricing and despite knowledge of heightened housing risk. The PMI expansion facilitated an unprecedented increase in Fannie Mae's and Freddie Mac's purchases of high-risk mortgages, extending the mortgage boom into 2007 and precipitating their collapse as well as that of the PMI industry. We argue that this unraveling reflects a general moral hazard problem associated with insurance providers coupled with misaligned incentives in the government-backed portion of the mortgage market.
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