subprime cohorts from 2001 to 2004 prepaid at or before 24 months of loan life. Prepayments for the 2005 and 2006 cohorts slowed dramatically, to about a 50 percent cumulative rate before 24 months for the 2005 cohort, and slower still at 20 months for the 2006 cohort. Declining house prices are inhibiting the ability of highly leveraged 2005 and 2006 borrowers to refinance. Also, an estimated 70 percent of subprime loans carry prepayment penalties as opposed to 2 percent of prime loans (Berson, 2006, Center for Responsible Lending, 2008).

**Geographic concentration of subprime lending has increased loss severity.** Agarwal, et al (2008) find that subprime loans tend to be concentrated geographically. In their study of the Phoenix, Arizona area, they find that subprime loans are found in primarily older neighborhoods in the inner city. As foreclosures surge in these older neighborhoods, they find that house prices decline more than in neighborhoods (or zip codes) with higher concentrations of prime loans. Thus, it is important to understand that high-risk lending in geographically concentrated areas can result in “default cascades” where they decline in property value can contribute to the decline in neighboring property values and increasing loss severities in these neighborhoods.

**As house prices have fallen and interest rates risen, subprime defaults and foreclosures have risen more than expected, but not necessarily because of ruthless defaults.** As highly leveraged borrowers find themselves with mortgage debt greater than the value of their homes, it is to be expected that many would “ruthlessly” default, leave the lender with the cost of disposing the property, and accept the damage to their credit records. Foote, et al (2008) show that the issue with falling house prices stems from the resulting vulnerability to personal financial shocks rather than the tendency to ruthlessly default. Households that have positive equity can sell or refinance, but those with negative equity and a personal financial shock such as job loss are more likely to be forced into foreclosure.

**Sixty percent of vintage 2006 subprime loans were made on a “stated income” basis, without any documentation or verification of the income of the borrower** (Fitch, 2007) **.** In considering the debt to income ratio, it is standard practice to verify the loan applicant’s income with evidence such as pay stubs, direct verification by employer, or tax returns. In emerging markets, informal borrowers may submit rent receipts, utility bills, payoffs of appliance loans, or contracted savings accounts. Less polite industry terms for stated income loans included “no doc,” “low doc,” or “liar loans.” While convenient for the borrower, such loans carry spreads of up to 500 basis points above prime lending rates. Stated income loans can make sense when the lender verifies assets and employment, and when the borrower has significant cash equity in the transaction. Historically, stated income loans have been made in limited numbers for self-employed professionals, or to refinance existing loans held by the lender. The lender could save time when it was familiar with the property, comfortable with the LTV of the new loan and with its knowledge of the borrower’s willingness and ability to pay. However, stated income lending became more widespread in the industry and it became riskier as lenders offered such loans on the expectation of rising house prices and without verifying assets. Studies cited by the OCC showed that borrowers exaggerated their income on 90 percent of surveyed stated income loans, that most incomes were exaggerated by more than 50

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