A dramatic shakeout in the US subprime-mortgage market has dominated financial headlines in recent months. Credit deterioration and liquidity freezes—which have had a swift and painful impact on lending and capital markets—are driving the cycle, with many large banks cutting back their exposure to subprime lenders. Nearly 50 percent of subprime origination capacity has either disappeared as a result of bankruptcy or been acquired at distressed valuations (Exhibit 1).

Despite this steep downturn, our view is that subprime-mortgage lending, which has risen from 10 percent of originations in 1998 to more than 22 percent recently, is unlikely to disappear. As Angelo Mozilo, CEO of Countrywide Financial, has noted, even in these difficult times more than 80 percent of subprime borrowers are still current on their principal and interest payments. Moreover, both Fannie Mae and Freddie Mac, the US government-sponsored enterprises that support liquidity in the home mortgage market, have recently announced plans to increase their subprime investments by tens of billions of dollars. Both have pledged to help delinquent subprime borrowers refinance into more affordable mortgages, thereby avoiding foreclosure, through new products such as 40-year mortgages...