Why Did the Subprime Market Collapse?
The important thing to remember is that a borrower on the brink of default has an exit option: prepay the mortgage either by refinancing or selling the property. Interestingly, Bhardwaj and Sengupta found that the total proportion of loans that either went into default or were prepaid remained unchanged across all vintages. More important, there was a significantly high incidence of early prepayments on subprime originations of earlier vintages. However, this was followed by a sharp drop in prepayment rates after 2006, suggesting that fewer borrowers could use the prepayment exit option. Why did prepayments decline for originations of later vintages? Herein lay the importance of the subprime mortgage design. Prepayments (either in the form of refinances or an outright sale of the property) were critical to the sustainability of subprime mortgages. In a regime of rising house prices, borrowers could avoid default by prepaying their loans (either through a refinance or a property sale).
