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.