Abstract
The 2007–2009 global financial crisis which originated in the U.S. subprime mortgage market and then spread to the whole financial system, drew attention to the impact that subprime lending and subprime mortgage securitization can have on the real economy. This paper explores the dynamics of the economy with a subprime mortgage market and the financial innovation in that sector when housing shocks arise. I develop a DSGE model with different types of borrowers and a shadow banking sector that is involved in subprime lending and securitization activities. The model shows that the process of securitizing risky credit amplifies the propagation of housing shocks in the economy through creating a link between the financial sector and the real sector.
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