Product Innovation & Mortgage Selection in the Subprime Era

Abstract

The introduction of subprime mortgage lending helped fill an unmet demand for mortgage credit by those who did not qualify for prime credit. The rapid growth of the subprime market provides indirect evidence that there were in the past (before subprime) and probably are again (after the subprime meltdown) many households who cannot purchase a home due to the lack of available mortgage products. Mortgage product innovation has made mortgage terms of art such as io (interest only) or neg-am (negative amortization) part of everyday parlance in the real estate business, but the last few years have also shown that very few institutional investors, underwriters, originators, or servicers fully understood the risks associated with these types of products. If these sophisticated market participants struggled with recent innovations it should come as no surprise that borrowers also struggled to understand them and utilize them effectively. Indeed, the great promise of subprime lending -- making homeownership feasible and an affordable reality for most Americans -- has instead turned into a financial debacle and a massive drag on the American economy.Since the use of exotic or alternative mortgage products played a role in the subprime meltdown, it is important to understand when these products make sense and how far the market deviated from rationality. The research presented here begins this analysis using a county level empirical examination of the mechanisms used to select different types of subprime mortgages from 2000 through July 2007. In particular we examine the use of adjustable rate loans, hybrid rate loans, interest only loans, non-amortizing loans, and loans with balloon payments. The empirical results indicate that the economic and financial incentives play a large part in determining what types of loans people used to finance their home. We also examine how the use of these types of mortgages changed over time and how much of those changes were driven by economic and financial fundamentals. We find substantial evidence of the misallocation of mortgage types over the 2004-2007 time period. This may help us to project what a sensible subprime mortgage market should look like in the future and how far the mortgage market deviated from that path.