President

lends a debtor money today, which the debtor must repay with interest in thefuture. Credit comes in many different forms: credit cards, automobile loans,mortgages, corporate bonds, and government bonds. Securities whose valueis derived from underlying assets are called derivatives or derivative securities.Credit markets are the markets in which loans and their derivative securitiesare traded.Consider mortgages. Suppose a person wants to purchase a house, butdoes not have enough cash on hand to buy it. The prospective borrower (thedebtor) uses his available cash as a down payment and approaches a lender(the creditor), who lends the borrower the remaining money needed to coverthe cost of the house. Over time, the borrower earns income from his joband pays off the mortgage (debt). Because money today is worth more thanmoney tomorrow, the lender charges interest on the amount of the loan(the principal). The interest rate must be set high enough to compensate thelender for bearing the risks associated with the loan but low enough to makethe loan attractive to the borrower.Mortgages, like most forms of credit, are subject to three forms of risk:credit risk (the risk that the debtor will default on the loan), interest rate risk(the risk that market interest rates will fluctuate), and prepayment risk (therisk that the borrower will pay off the loan early). Lenders make money bycharging borrowers interest payments on top of the periodic repayments ofprincipal. Therefore, the lender is worse off if these interest payments stop,such as when the borrower defaults on a loan or pays off the loan early in anenvironment of low interest rates. Mortgage lenders may also face the risk of aloss of principal if a property is foreclosed upon. Loans with greater risk havehigher interest rates to compensate the lender for bearing more risk.Recent Developments in Mortgage MarketsFrom 2001 to 2007, there was a substantial increase in the use of subprimemortgages. (Box 2-1 defines “subprime mortgages” and other mortgagemarket terminology.) The share of mortgage originations that were subprimeincreased from 5 percent in 2001 to more than 20 percent in 2006. Subprimemortgages carry a greater risk than prime mortgages. Many subprimeborrowers have poorer credit histories and less reliable sources of income thanprime borrowers; they may provide little or no documentation of income orassets from which they can pay the mortgage; and they tend to have highloan-to-value ratios. As a result, compared with prime borrowers, subprimeborrowers are more likely to default on their loans.Chapter 2 | 53