Liquidity Provision, Credit Risk and the Bond Spread: New Evidence from the Subprime Mortgage Market

Abstract

We study the determinants of the subprime mortgage loan spread, with a particular focus on funding liquidity and default-liquidity interaction effects. We find that sector-level as well as macro funding liquidity provision affected subprime loan rates, explaining a significant portion of the variation in spreads. Liquidity conditions just prior to loan default mattered, indicating destabilizing liquidity-driven default effects. A reduction in macro funding liquidity provision at the time of loan origination predicts worsening credit performance, implying a stabilizing default-driven liquidity component in the loan spread. Positive default-liquidity feedback (spiraling) effects are also documented.

Keywords: Bond Pricing, Liquidity, Credit Risk, Subprime Mortgage, Securitization

JEL Classification: E32, E44, E51, G12, G32, L85