The Rise and Fall of Subprime Mortgages

This reading, "The Rise and Fall of Subprime Mortgages." provides a thorough introduction to subprime mortgages and the problems they have created in financial markets. It discusses the traditional mortgage market, the growth of nontraditional (subprime) mortgages as a share of new mortgages during this decade, the risks of subprime lending, the downturn in the housing market, and the problems experienced by financial institutions that invested in securities backed by subprime mortgages. It also considers the macroeconomic effects of the housing downturn and possible monetary policy responses that might mitigate them.

1. Define the following terms used in the reading:
   1. prime mortgage
   2. jumbo mortgage
   3. subprime mortgage
   4. default risk
   5. near-prime mortgage
   6. credit scoring
   7. residential mortgage-backed securities (RMBS)
   8. government-sponsored enterprises (GSEs)
   9. collateralized debt obligations (CDOs)
   10. past-due rates
   11. no-doc loans
   12. adjustable-rate mortgages (ARMs)
   13. synthetic values
   14. illiquidity
   15. risk premiums

2. In general, how do subprime and near-prime mortgages differ from prime mortgages?
   1. Describe the channels through which funds flow from savers and investors into each mortgage category.
   2. What proportion of outstanding mortgages in the United States fall in each category?
   3. What factors do DiMartino and Duca cite as responsible for the rapid growth of subprime mortgages over the period 2001 to 2006?
   4. How has the growth of subprime mortgage lending impacted homeownership in the United States?
   5. How has it affected the quality of outstanding mortgage loans?

3. What problems and concerns regarding the quality of subprime mortgage began to gain attention in 2006 and 2007, but not earlier in the decade?
   1. How have mortgage lenders reacted to growing concerns about subprime mortgages?
   2. How has this affected the housing market?

4. What serious problems did deteriorating quality of subprime mortgage loans create for financial markets and institutions?

5. How might the problems in housing and financial markets affect the macroeconomy? What policies might the Federal Reserve use to avoid these effects?

Source: "The Rise and Fall of Subprime Mortgages." Danielle DiMartino and John V. Duca, Economic Letter 2(11), Federal Reserve Bank of Dallas, November 2007.