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2. Screening Cost, Credit Risk, And The Optimal Structure Of Mortgage Lending—Origin Of The Subprime Mortgage Crisis, Pingkang Yu

Pingkang Yu

This paper attempts to answer a direct question—who should get mortgage credit and how should that credit be supplied? This question is at the heart of the recent subprime crisis and the efforts to reform mortgage lending through new regulations. This paper develops a credit market model with borrower’s self-selection and lender’s costly screening. Borrowers in the model differ in both screening cost and credit risk. In particular, the model includes fraudulent borrowers and low-risk-high-documentation-cost borrowers. The paper finds that separating equilibrium, where specialized lender serves the targeted type of borrower, is the only feasible market structure in the long …