On the Economics of Subprime Lending

US mortgage markets have evolved radically in recent years. An important part of the change has been the rise of the Bsubprime ^ 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 Bstylized 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 informationYone 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