Borrower Self-Selection, Underwriting Costs, and
Subprime Mortgage Credit Supply
Department of Economics, University of Maryland, College Park, MD 20742, USA
Research Division, Federal Reserve Bank of St. Louis, St. Louis, MO 63102, USA
Department of Economics, The George Washington University, Washington, DC 20052, USA
In the U.S., households participate in two very different types of credit markets. Personal lending is
characterized by continuous risk-based pricing in which lenders offer households a continuous distribution of
borrowing possibilities based on estimates of their creditworthiness. This contrasts sharply with mortgage
markets where lenders specialize in specific risk categories of borrowers and mortgage supply is stepwise
linear. The contrast between continuous lending for personal loans and discrete lending by specialized lenders
for mortgage credit has led to concerns regarding the efficiency and equity of mortgage lending.
This paper sheds both theoretical and empirical light on the differences in the two credit markets. The theory
section demonstrates why, in a perfectly competitive credit market where all lenders have the same
underwriting technology, mortgage credit supply curves are stepwise linear and lenders specialize in prime or
subprime lending. The empirical section then provides evidence that borrowers are being effectively sorted
based on risk characteristics by the market.
Key Words: subprime, lending, mortgage, self-selection, market segmentation, credit, predatory lending
This paper is motivated by two stylized facts that distinguish the market for personal
credit from the mortgage credit market. First, there are fundamental differences in the
credit supply function between personal loan markets and mortgage markets. U.S.
households face a continuous supply of personal credit from lenders. That is, individual
lenders offer personal loans and revolving credit at rates that reflect the continuous
distribution of consumer credit risk in the market. In contrast, mortgage credit is split
into Bprime^ and Bsubprime^ markets in which lenders specialize and the effective credit
supply function is stepwise linear. The more or less continuous pricing of credit in
personal loan markets contrasts with mortgage markets where price increases as a step
The Journal of Real Estate Finance and Economics, 30:2, 197–219, 2005
2005 Springer Science + Business Media, Inc. Manufactured in The Netherlands.