Abstract
This paper develops an equilibrium model of a subprime mortgage market. The model is analytically tractable and delivers plausible orders of magnitude for borrowing capacities, loan-to-income ratios, home prices, and default and trading intensities. We offer simple explanations for several phenomena in the subprime market, such as the prevalence of “teaser rates” and the clustering of defaults. In our model, the degree of income co-movement among households plays an important role. We find that both systematic and idiosyncratic income risks reduce debt capacities, although through quite distinct channels, and that debt capacities and home prices need not be higher when a larger fraction of income risk is idiosyncratic.
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