We study optimal lending behavior in situations where borrowers’ outside options increase with their creditworthiness. Creditworthiness is private information of borrowers. Lenders use collateral as a screening mechanism to address this adverse selection problem. A lender seeking to attract creditworthy borrowers with high reservation payoffs (while screening out uncreditworthy types) must offer contracts with sufficiently low interest rates and, consequently, high collateral requirements. Because higher collateral requirements raise screening costs, however, lenders favor pooling uncreditworthy borrowers over screening them—in essence, a lowering of credit standards. Lending costs determine break-even offers that rival incumbents can offer borrowers. Accordingly, a lender faces borrowers whose reservation payoffs depend on the lender’s cost advantage over rival incumbent lenders. Our results imply that screening is more likely to occur in markets with a greater disparity in lending costs. Conversely, when funding markets are intensely competitive, lenders are more likely to resort to pooling. This paper also rationalizes the phenomenon of cream-skimming by outside (foreign) lenders as an equilibrium of the model. Surprisingly, we find that the presence of an informed rival actually facilitates cream-skimming by an uninformed lender.

Loan performance of subprime originations during the boom years of 2004–2006 is contrasted with that of subprime originations during the early period of 2000–2002. A counterfactual technique is developed to determine how originations during the early period would perform in a different environment, namely, the environment faced by originations of 2004, 2005, and 2006. In an environment where house prices are increasing rapidly, low credit score originations do not show high rates of default—as was witnessed for 2000–2002 cohorts. However, in an environment of stagnant or deteriorating home prices, low credit score originations show significantly higher rates of default than high credit score originations. With a greater proportion of low credit score originations, earlier cohorts of 2000–2002 were no less vulnerable to the environment faced by cohorts of 2004–2006. In essence, these results raise concerns about the viability of all cohorts of subprime originations because of their reliance on the appreciation of the underlying collateral rather than the creditworthiness of the borrower.

This paper offers evidence on the design of subprime mortgages as bridge-financing products. We show that the viability of subprime mortgages was uniquely predicated on the appreciation of house prices over short horizons. High rates of early prepayments on subprime mortgages suggest the use of prepayments as an exit option. This paper argues that high early defaults on post-2004 originations can be explained when one considers high early prepayment rates for pre-2004 originations.