Mortgage Rates and Credit Risk: Evidence from Mortgage Pools

We study interest rates on mortgages using the segmentation adopted in the process of securitization: Mortgages securitized by government-sponsored enterprises; mortgages securitized by private institutions, in turn divided in prime and subprime mortgage pools; and, finally, mortgages held by intermediaries on their balance sheet. We find that, over the period that goes from the mid nineties to present, all mortgage classes were priced equally with the exception of subprime loans. Subprime loans were priced in function of the credit worthiness of the borrower. This process however, was not uniform over time. The crucial aspect of the pricing process is that credit risk becomes increasingly important from (at least) the mid-90's to the crisis of 2008. Moreover, through cointegration analysis we find that the dynamics of delinquencies and, to a lesser extent, housing price are reflected in the dynamics of subprime mortgage rates, and not in other mortgage categories. The evidence documents the importance of the subprime mortgage securitization process and indicates that the willingness of financial markets to support a higher level of credit risk is quantitatively important and dates back at least ten or fifteen years before the crisis.