Detecting and explaining systemic risks of mortgage banks—evidence from the subprime crisis

Abstract

In recent history, financial markets worldwide experienced severe turmoil due to the subprime crisis originating from the practice of US mortgage banks to securitize loans given especially to subprime borrowers. In the same crisis, several distressed banks were bailed out by states with even more banks receiving financial aids from governments. Using a unique data sample of 100 announcements of US mortgage banks between 2006 and 2009, this paper provides empirical evidence that isolated failures of US mortgage banks caused significant contagion effects in the US financial system. Conversely, especially the bailouts of Fannie Mae and Freddie Mac led to significant positive valuation effects at rival banks. In the cross-sectional analyses, contrary to previous studies in the literature on past financial crises, we find evidence for pure contagion effects following the failures of US mortgage banks. Furthermore, we analyze the reactions of the CDS spreads of several large US banks to the announcements of mortgage banks using a novel mixture copula model. The results show that the contagion effects were limited to the stock market thus underlining the notion of an irrational response of (stock) market participants. The results from our cross-sectional and CDS data analyses in turn indicate that several of the failures of US mortgage banks during the subprime crisis caused irrational contagion in the US financial system thus justifying government intervention. Finally, we rule out the possibility that the contagion effects limited to the US stock market were caused by a herding of investors.