CDO Market Implosion and the Pricing of Subprime Mortgage-Backed Securities

Abstract

We evaluate the effects of CDO issuance on the pricing of subprime mortgage-backed securities. Upon controlling for mortgage option values and other well-established determinants of credit spreads, GMM results indicate that the emergence and rapid capitalization of the subprime-backed CDO market was associated with a significant tightening of subprime MBS/Treasury yield spreads. Results of VAR and other robustness tests serve to corroborate the findings. Dynamic simulation based on the impulse response functions shows substantial subprime MBS spread widening in the wake of implosion in the CDO market. Those effects likely were passed back to the primary market in the form of diminished investor demand and related reduced pricing of subprime loans. Research findings also suggest the importance of supply/demand shocks associated with innovations in derivative securities markets to the pricing of securitized subprime debt.