We study early default, defined as serious delinquency or foreclosure in the first year, among nonprime mortgages from the 2001 to 2007 vintages. After documenting a dramatic rise in such defaults and discussing their correlates, we examine two primary explanations: changes in underwriting standards that took place over this period and changes in the economic environment. We find that while credit standards were important in determining the probability of an early default, changes in the economy after 2004 especially a sharp reversal in house price appreciation—were the more critical factor in the increase in default rates.

A notable additional result is that despite our rich set of covariates, much of the increase remains unexplained, even in retrospect. Thus, the fact that the credit markets seemed surprised by the rate of early defaults in the 2006 and 2007 non prime vintages becomes more understandable.

Rapid increases in US residential mortgage defaults during 2007 and into 2008 captured the attention of researchers, the public and policy makers, and had a chilling effect on credit markets worldwide. While these increases were noted originally in the non prime market, foreclosure increases have in more recent months begun to spill over into the prime market. This paper studies a part of this phenomenon, early defaults in the non prime market.

Historically, four key characteristics (“risk factors” or “underwriting criteria”) have been
thought to determine the probability that a mortgagor will default. Those factors are the loan-to-
value ratio (LTV) 1, the debt service-to-income ratio (DTI), the mortgagor’s credit score, and the extent to which the mortgagor’s income and assets have been verified by third party sources such as employers, tax returns, and bank account statements. To expand the potential pool of borrowers, non prime (subprime and alt-a) mortgages by design relaxed one or more of these underwriting criteria beyond the margins required for prime mortgage loans. A direct consequence is that we would expect the default experience of these relatively new mortgage products to be worse than that of prime loans. Indeed, industry data confirm that the performance of the very first vintages of non prime loans was significantly worse than that of prime loans.

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