Prepayments and the Subprime Market

Here’s the abstract of a recent paper:

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 fi…nancial burden on reset to the fully indexed rate. In a
regime of rising house prices, a fi…nancially 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).

Posted by on January 6th, 2009 at 12:01 am


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