A Theory of Subprime Mortgage Lending with Appliactions to The Rise and Fall of the Subprime Conduit Mortgage Market

We present a general equilibrium model of a subprime economy characterized by limited recourse mortgages, asymmetric borrower credit quality information, and mortgage lenders that either own or sell the loans they originate. We identify sev-eral components in the equilibrium mortgage rate, including the access to soft credit information, the foreclosure recovery rate, and the liquidity in the securitized invest-ment market. We show that the equilibrium size of the subprime lending market can expand and contract depending on the access to liquidity in the securitized invest-ment market and the predictive power of the credit scoring technology. Our theory rationalizes the emergence of the subprime conduit mortgage market and subsequent collapse of the traditional lending model, and also the recent rise and fall of the subprime conduit mortgage market. In addition, the model sheds some light on the access to and fragmentation of the rental and owner-occupied segments of the housing market. A number of extensions to the model are considered to assess its robustness. Key words: subprime lending; soft information; credit scoring technology; port-folio lenders; conduit lenders; originate-to-distribute lending model; equilibrium; mortgage market collapses