On the Economics of Subprime Lending

Abstract

US mortgage markets have evolved radically in recent years. An important part of the change has been the rise of the “subprime” market, characterized by loans with high default rates, dominance by specialized subprime lenders rather than full-service lenders, and little coverage by the secondary mortgage market. In this paper, we examine these and other “stylized facts” with standard tools used by financial economists to describe market structure in other contexts. We use three models to examine market structure: an option-based approach to mortgage pricing in which we argue that subprime options are different from prime options, causing different contracts and prices; and two models based on asymmetric information–one with asymmetry between borrowers and lenders, and one with the asymmetry between lenders and the secondary market. In both of the asymmetric-information models, investors set up incentives for borrowers or loan sellers to reveal information, primarily through costs of rejection. Copyright Springer Science + Business Media, Inc. 2004asymmetric information, licensing, option-pricing, secondary market, signaling, subprime mortgage market,

The Subprime Crisis and House Price Appreciation

“…See, for example Downing, Wallace and Stanton (2005) and Crews Cutts and Van Order (2005). 8 The policy implications of the subprime mortgage market are further explored in Wachter, Russo and Hershaff (2005) and Calem, Gillen and Wachter (2003).…”

Quick Exits of Subprime Mortgages

“…In a more recent, but precrisis analysis, Cutts and Van Order (2005) suggest that several economic models can, in fact, explain the main characteristics of the subprime market. In particular, "option-based" models are consistent with pricing and loan characteristics of subprime mortgages (for example, improving a borrower's credit score makes refinancing more likely); "separating equilibrium" models sort borrowers into prime and subprime markets through signaling mechanisms; and "adverse selection" models are consistent with the choice between the lower costs of the secondary market and the information advantages of the primary market.…”

The Sixth Kondratieff Cycle the Era of Financial Market Instruments: A Reflection on the Australia vs US Subprime Mortgage Market

“…Subprime lending in the residential mortgage market grew to satisfy the demand for homeownership by borrowers who did not necessarily meet the credit standards required by prime market lenders (An & Bostic 2007: Cutts & Van Order, 2005: Gilkeson & Smith 1992. In the US these loans were targeted at borrowers with low and moderate incomes thus many of the loans were approved on the home buyers' ability to pay only the low introductory rate.…”

“…The classification of these eras highlights the unique characteristics inherent in each of the historical periods. When this is applied to the present financial crisis the unique characteristic is identifiable as being the subprime lending in the residential mortgage market and the growth of financial market instruments such as derivatives (An & Bostic 2007: Cutts & Van Order, 2005: Gilkeson & Smith 1992. A pertinent factor in the evaluation process is that in each of the previous eras there were incremental and fundamental innovations which triggered a creative period and generated growth that influenced society and the economies of countries before resulting in a global crisis.…”