Using loan level data, we provide evidence consistent with risk-shifting in the lending
behavior of a large subprime mortgage originator { New Century Financial Corporation
{ starting in 2004. This change follows the monetary policy tightening implemented
by the Fed in the spring of 2004, which resulted in an adverse shock to
the large portfolio of loans New Century was holding for investment. New Century
reacted to this shock by massively resorting to deferred amortization loan contracts
(interest-only” loans). We show that these loans were not only riskier, but also that
their returns were by design more sensitive to real estate prices than standard contracts.
New Century was thus nancing projects with a high beta on its own survival,
as predicted by a standard model of portfolio selection in nancial distress. Our ndings
contribute to better characterizing the type of risk taken by nancially distressed
rms. They also shed new light on the relationship between monetary policy and risk
taking by nancial institutions.