This paper examines the role of mortgage supply characteristics in both affordability and financial risk outcomes, in the wake of the mortgage crisis. A hallmark of the crisis was a shift in mortgage lending products(shown in Figure1). What impact did this shift have on consumers, investors and the overall financial system? In an effort to better understand the impact of various products on affordability as well as financial risk outcomes, we address the performance of these products and their interaction with the financial sector in the production of systemic risk. While ex post the performance of these mortgages was disastrous and neither expected nor priced, we also show that ex ante credit risk was mispriced. The links between mortgage lending instruments, such as interest only, negative amortization or subprime mortgages, and underlying house price volatility  and associated risks have been explored in recent empirical and theoretical research. While it may seem obvious that such instruments allow more borrowing than otherwise would occur in previously affordability and credit score-constrained markets, and prices rise as a result, the relationship may very well go both ways. That is, it is possible that markets with rising prices invite more supply of nontraditional mortgage products, and, under certain conditions, this could occur without an increase in credit risk, for example, if there is an innovation in lending technology that better discriminates good from bad risks.

This paper reviews the literature on this question, summarizing models in which the expansion of nontraditional mortgages (NTM)is associated with a decrease as well as an increase in overall financial risk. Increased risk may come from several sources. First, it is possible that the expansion of NTM occurs along with the easing of credit constraints and underwriting standards associated with increased default risk; in short, increasing lending to riskier borrowers. Secondly, it is possible that the mortgage instruments themselves are riskier.). Third, it is possible that the risk due to either of these factors is not priced. But as noted it also possible that an increase in NTM occurs without an increase in risk but rather with a decrease in risk. That is, NTM expands when prices expand, and this is rational because prices increase due to a decline in risk as a result of an innovation in mortgage lending technology.