Credit Spreads: Evidence from the Mortgage Market

Using micro-level data from the mortgage market, we examine yield spreads as a funnction of both credit risk and prepayment risk using a two-stage instrumental variable approach. Our results are consistent with findings in the finance literature that leverageinduced financial risk reflected in capital structure results in higher yield spreads on debt. In particular, borrowers with loan-to-value ratios less than 80 percent have credit spreads 14, 21, and 22 basis points lower than borrowers with LTV ratios between 80 and 85 percent, between 86 and 90 percent, and greater than 90 percent, respectively. We also find evidence that securitization reduces credit spreads by between 5-10%.