Econometric Regime Shifts and the US Subprime Bubble

Abstract

Using aggregate quarterly data for the period 1975q1–2010q4, I find that the US housing market changed from a stable regime with prices determined by fundamentals, to a highly unstable regime at the beginning of the previous decade. My results indicate that these imbalances could have been detected with the aid of real time econometric modeling and that they were caused by the sharp rise in subprime lending in the early to mid 2000s. These results are based on the detection of huge parameter non-constancies and a loss of equilibrium correction in two theory derived cointegrating relationships shown to be very stable for earlier periods. Controlling for the increased subprime exposure during this period, enables me to reestablish the pre-break relationships also for the full sample. This suggests that the US housing bubble was caused by the increased borrowing to a more risky segment of the market, which may have allowed for a latent frenzy behavior that previously was constrained by the lack of financing. With reference to Stiglitz’s general conception of a bubble, I use the econometric results to construct two bubble indicators, which clearly demonstrate the transition to an unstable regime. Such indicators can be part of an early warning system and are shown to Granger cause a set of coincident indicators and financial (in)stability measures.