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Did Prepayments Sustain the Subprime Market?

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  • Bhardwaj, G.
  • Sengupta, R.

    (Tilburg University, Center for Economic Research)

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    Abstract

    This paper demonstrates that the reason for widespread default of mortgages in the subprime market was a sudden reversal in the house price appreciation of the early 2000's. Using loan-level data on subprime mortgages, we observe that the majority of subprime loans were hybrid adjustable rate mortgages, designed to impose substantial financial burden on reset to the fully indexed rate. In a regime of rising house prices, a financially distressed borrower could avoid default by prepaying the loan and our results indicate that subprime mortgages originated between 1998 and 2005 had extremely high prepayment rates. Most important, prepayment rates on subprime mortgages were extremely high (i) not just for ARMs but FRMs as well, (ii) even before the reset dates on hybrid-ARMs and (iii) despite prepayment penalties on the contract. However, a sudden reversal in house price appreciation increased default in this market because it made this prepayment exit option cost-prohibitive. In short, prepayments sustained the subprime boom and the extremely high default rates on 2006-2007 vintages were largely due to the inability of these mortgages to prepay (an option that was available for mortgages of earlier vintages).

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    Bibliographic Info

    Paper provided by Tilburg University, Center for Economic Research in its series Discussion Paper with number 2009-38 S.

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    Date of creation: 2009
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    Handle: RePEc:dgr:kubcen:200938s

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    Web page: http://center.uvt.nl

    Related research

    Keywords: mortgages; subprime; refinance; prepayment; crisis;

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    1. Souphala Chomsisengphet & Anthony Pennington-Cross, 2006. "The evolution of the subprime mortgage market," Review, Federal Reserve Bank of St. Louis, issue Jan, pages 31-56.
    2. Geetesh Bhardwaj & Rajdeep Sengupta, 2008. "Where's the smoking gun? a study of underwriting standards for US subprime mortgages," Working Papers 2008-036, Federal Reserve Bank of St. Louis.
    3. Paul Bennett & Richard Peach & Stavros Peristiani, 1998. "Structural change in the mortgage market and the propensity to refinance," Staff Reports 45, Federal Reserve Bank of New York.
    4. Kau, James B, et al, 1993. "Option Theory and Floating-Rate Securities with a Comparison of Adjustable- and Fixed-Rate Mortgages," The Journal of Business, University of Chicago Press, vol. 66(4), pages 595-618, October.
    5. Gary Gorton, 2008. "The Panic of 2007," Yale School of Management Working Papers amz2372, Yale School of Management.
    6. Ambrose, Brent W & Sanders, Anthony B, 2003. "Commercial Mortgage-Backed Securities: Prepayment and Default," The Journal of Real Estate Finance and Economics, Springer, vol. 26(2-3), pages 179-96, March-May.
    7. Hurst, Erik & Stafford, Frank, 2004. "Home Is Where the Equity Is: Mortgage Refinancing and Household Consumption," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 36(6), pages 985-1014, December.
    8. Craig P. Aubuchon & David C. Wheelock, 2008. "How much have U.S. house prices fallen?," National Economic Trends, Federal Reserve Bank of St. Louis, issue Aug.
    9. Caplin, Andrew & Freeman, Charles & Tracy, Joseph, 1997. "Collateral Damage: Refinancing Constraints and Regional Recessions," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 29(4), pages 496-516, November.
    10. Karl E. Case & Robert J. Shiller, 2003. "Is There a Bubble in the Housing Market?," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 34(2), pages 299-362.
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