The Subprime Virus1 Sumit Agarwal, Ph.D. Federal Reserve Bank of Chicago Brent W. Ambrose, Ph.D. Penn State University Yildiray Yildirim, Ph.D. Syracuse University The subprime mortgage market experienced rapid growth during the housing boom of the early to mid-2000s. However, when the housing market began to collapse in 2007 new subprime mortgage originations virtually disappeared. The strong correlation between house prices and subprime origination activity led many to blame the subprime mortgage market for the housing crisis. In fact, a large and growing body of financial economics literature examines the role subprime played in the financial crisis. Since subprime loans were riskier than prime loans by definition, it is not surprising that they have had high levels of foreclosure (relative to prime loans) during the housing crisis. Recently, research has turned to the negative externalities that the subprime market imposed on other markets. For example, research has shown that homes in foreclosure sell at a significant discount, which then reduces the values of surrounding properties. If subprime mortgages have higher rates of default, they may impose significant costs on other homeowners in the same geographic location. In our paper, we investigate whether the subprime mortgage market imposed negative externalities on the prime mortgage market. We want to know to what extent the presence of subprime mortgages in an area affects the value of prime mortgages in the same location. Stated differently, did the introduction of subprime mortgage loans into an area increase the risk profile of prime mortgages in that same location. 1 This article is adapted from Agarwal, Sumit, Brent W. Ambrose and Yildiray Yildirim, 2012, “The Subprime Virus”, working paper. Our question has implications for financial regulations. An easy place to see this is in the context of capital requirements for banks. For example, suppose a “safe” bank holds only lowrisk prime mortgages. Due to the low risk of its assets, this bank will be subject to low capital requirements. Now suppose that a subprime lender begins to originate loans in the same location as the bank, and that these loans increase the risk profile of the bank’s prime loans. If regulators care about the total risk of the bank’s assets, then the bank’s capital requirements should increase when the subprime lender enters the market. To examine subprime spillover effects in the prime mortgage market, we first introduce a default model based on Merton (1974). The intuition of the model is as follows. A rational individual defaults only when the value of his house is less than the value of his mortgage. Upon default, the bank forecloses on the house, and sells it in the market at a discount. Since the foreclosed house sells at a discount, it reduces the average house value in its geographic location. Because the value of an individual’s house is partially based on average house values in the area, the foreclosure acts to depress the value of nearby houses, thus making foreclosure more likely on those houses. In other words, the foreclosure imposed negative externalities on surrounding homeowners. Since subprime borrowers are more likely to default, areas with high levels of subprime mortgage activity will also impose high costs on prime borrowers in those same areas. Stated differently, the default risk of prime mortgage loans will be higher in areas with high levels of subprime mortgage activity. We use the model to run simulations meant to capture the effect of introducing high risk mortgages (subprime) into an area that previously had only low risk mortgages (prime). The results of our simulations provide us with several testable hypotheses. First, prime mortgage defaults will be higher in areas with higher house price volatility. Second, as the share of subprime mortgages increases in an area, the probability of default on the prime mortgages increases, or stated differently, the introduction of subprime mortgages increases the default risk on existing prime mortgages. Finally, the magnitude of the spillover effects from subprime mortgages to prime mortgages depends on housing volatility; increased house price volatility mutes the spillover effects. Assuming the annual volatility of house prices is 10%, moving from 0 to 75% subprime market share makes default on prime loans 3.5 times more likely. In contrast, with 30% house price volatility, the same shift in subprime market share causes prime loans to be 2.7 times more likely to default. Regardless of our assumptions about volatility, the entrance of a subprime lender into a specific area decreases the value of the portfolio of existing prime mortgages by increasing default risk on the prime loans. To test our hypotheses, we employ a large loan database that covers the majority of residential mortgage loans. Our sample period is 2003 thru 2007. For each zip-code in our sample, we compute quarterly subprime market share and prime mortgage default rates. Since our simulation starts with a market that only has prime loans, we include only the zip-codes that had very little subprime penetration at the beginning of our sample period. Prior to the introduction of subprime mortgages, when our zip-codes are all “prime” mortgage areas, the average default rate of prime mortgages was 1.57%. If subprime becomes a significant portion of mortgage market share in a zip-code, we then classify that zip code as a “non-prime” area. Over our sample period the prime mortgage default rates in non-prime areas are significantly higher than in areas with little subprime origination activity. For example, in the first quarter of 2004, prime mortgage default rates were almost an entire point higher in non-prime areas. Although over time defaults rates on prime mortgages increase in all markets, these default rates increase much faster in non-prime areas. This suggests that in a specific location subprime mortgages make the portfolio of prime mortgages riskier. Next we turn to regression analysis to control for house price changes, house price volatility, zip-code risk characteristics, and zip-code demographic characteristics. Consistent with previous research, we find that house price growth lowers prime rates of default, while a higher minority concentration and unemployment rate are related to higher prime mortgage default rates. Zip-codes with higher average credit scores experience lower default rates, ceteris paribus. In support of our model’s first testable hypothesis, we find that areas with higher house price volatility experience greater prime mortgage default. Turning to our variables of interest, we find that subprime activity increases prime mortgage default rates. A one point increase in subprime concentration increases prime mortgage default rates by roughly 0.5%. In addition, we find that subprime mortgage default rates are positively related to higher prime default rates. A one point increase in an area’s subprime default rate increases prime default rates by 9%, all else equal. These results suggest that subprime effects do in fact spillover into the prime mortgage market2. In sum, our empirical results support the predictions of the theoretical model. Increased subprime origination activity is positively related to prime mortgage default rates. Also, higher levels of subprime foreclosures are associated with higher prime mortgage defaults. Our results suggest that subprime mortgage origination imposed negative externalities on the prime mortgage market, or stated differently, the negative effects of 2 We also include robustness checks to attenuate concerns of omitted area risk factors and the endogeneity between subprime market share and prime default rates. Our primary results remain unchanged. subprime mortgages spilled over into the prime mortgage market. The externalities caused by the subprime mortgage market provide an economic rationale for financial regulation.