2. Screening Cost, Credit Risk, and the Optimal Structure of Mortgage Lending—Origin of the Subprime Mortgage Crisis(2011)
AbstractThis paper attempts to answer a direct question—who should get mortgage credit and how should that credit be supplied? This question is at the heart of the recent subprime crisis and the efforts to reform mortgage lending through new regulations. This paper develops a credit market model with borrower’s self-selection and lender’s costly screening. Borrowers in the model differ in both screening cost and credit risk. In particular, the model includes fraudulent borrowers and low-risk-high-documentation-cost borrowers. The paper finds that separating equilibrium, where specialized lender serves the targeted type of borrower, is the only feasible market structure in the long run. In the short run, when the screening cost changes due to the change of screening technology or financial innovations, a host of pooling equilibria can emerge. However, all the robust pooling equilibria are those pooled with fraudulent borrowers without lender’s screening. This establishes the channel through which the fraudulent borrowers enter and eventually destroy the market, and make the market structure switch back to separating. From the perspective of screening cost, this paper provides explanations to many stylized facts in the mortgage market in the past twenty years, such as the failure of low-documentation loan and the negative effect of securitization. It sheds light on the origin of the recent subprime mortgage crisis and means to evaluate and regulate future financial innovations.
- screening cost,
- credit risk,
- market structure
Citation InformationPingkang Yu. "2. Screening Cost, Credit Risk, and the Optimal Structure of Mortgage Lending—Origin of the Subprime Mortgage Crisis" (2011)
Available at: http://works.bepress.com/pingkang_yu/22/