Finance and Economics Discussion Series

The Past, Present, and Future of Subprime Mortgages

Shane M. Sherlund
2008-63

Abstract: This paper models the historical default and prepayment behavior for subprime mortgages using data on securitized mortgages originated from 2000 to 2007. I find that more recently originated subprime loans are more likely to default, well ahead of their first mortgage rate resets, and less likely to prepay (i.e., refinance). This rise in mortgage defaults stems largely from unprecedented declines in house prices, along with slack underwriting and tight credit market conditions. I estimate a competing hazards model to quantify the effects of (1) house price appreciation, (2) underwriting standards, (3) mortgage rate resets, and (4) household cash flow shocks, such as job loss and oil price increases, on the likelihood of borrowers with subprime mortgages to default or prepay. Ultimately, I find that borrower leverage is one of the most important factors explaining both default and prepayment for borrowers with subprime mortgages. Then, using several different assumptions about the future path of house prices, I simulate potential trajectories for subprime mortgage defaults between 2008 and 2010. Further, I explore the short-term sensitivities of default and prepayment to house prices and various mortgage characteristics.

Keywords: Subprime mortgages, default, prepayment