The Subprime Virus: Theory and Evidence

Abstract

We develop a theoretical model demonstrating the potential spillover effects associated with the introduction of risky assets. Specifcally, we examine the potential increase in mortgage default risk on prime mortgages that results from the introduction of subprime mortgages in a local area. The transmission mechanism is that the higher incidence of default by subprime borrowers leads to greater asset price volatility, which in turn impacts the default probability of prime mortgages in the same geographic area. Through numerical analysis, we demonstrate the impact of the origination of subprime mortgages to the risk of a portfolio of prime mortgages. Finally, we offer empirical support for our model by examining the spatial variation in MSA prime mortgage default rates correlated with the level of subprime mortgage activity.

Keywords: Subprime, Default, Portfolio Risk

JEL Classification: G2, R2