Journal of Real Estate Finance and Economics, 29:4, 457±477, 2004
# 2004 Kluwer Academic Publishers. Manufactured in The Netherlands.
What Drives Default and Prepayment on Subprime
Division of Research and Statistics, Federal Reserve Board, Washington, DC 20551, U.S.A.
Department of Economics, University of Texas at Austin, Austin, TX 78712, U.S.A.
This paper uses novel data on the performance of loan pools underlying asset-backed securities to estimate a
competing risks model of default and prepayment on subprime automobile loans. We ®nd that prepayment rates
increase rapidly with loan age but are not affected by prevailing market interest rates. Default rates are much more
sensitive to aggregate shocks than are prepayment rates. Increases in unemployment precede increases in default
rates, suggesting that defaults on subprime automobile loans are driven largely by shocks to household liquidity.
There are signi®cant differences in the default and prepayment rates faced by different subprime lenders. Those
lenders that charge the highest interest rates experience the highest default rates, but also experience somewhat
lower prepayment rates. We conjecture that there is substantial heterogeneity among subprime borrowers, and
that different lenders target different segments of the subprime market. Because of their higher default rates, loans
that carry the highest interest rates do not appear to yield the highest expected returns.
Key Words: subprime lending, hazard models, retail credit, auto loans, asset-backed securities
While lending to all types of households increased substantially during the 1990s, lending
to households with limited ®nancial resources and/or short or impaired credit historiesÐ
so-called subprime borrowersÐhas drawn particular attention from policymakers and
bank regulators. Anecdotal evidence that subprime lenders have encouraged borrowers to
re®nance loans on unfavorable terms or have embedded obscure but expensive covenants
in loan contracts have led to accusations that subprime lenders engage in ``predatory''
lending practices. The Home Ownership and Equity Protection Act, as well as legislation
adopted by some state and municipal governments, has sought to redress these concerns by
imposing additional reporting requirements and limiting speci®c pricing policies and
covenants on high-cost residential mortgages (Elliehausen and Staten 2004).
Even when loans are priced fairly, subprime borrowers, who by and large have lower
and more volatile income and fewer assets than prime borrowers, may have particular
dif®culty making regular debt payments during times of economic stress. Bank regulators
tasked with ensuring the safety and soundness of the U.S. banking system have focused on