Did Prepayments Sustain the Subprime Market?
AbstractThis 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 InfoPaper provided by Tilburg University, Center for Economic Research in its series Discussion Paper with number 2009-38 S.
Date of creation: 2009
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Web page: http://center.uvt.nl
mortgages; subprime; refinance; prepayment; crisis;
Find related papers by JEL classification:
- G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
- D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
- D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
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