Abstract
Several policy options have been discussed to mitigate the current subprime mortgage crisis. This paper analyses an interest rate freeze on adjustable rate mortgages as one possible reaction. In particular, the implications on Residential Mortgage Backed Securities (RMBS) are studied. We examine shifts in the underlying portfolio’s discounted cash flow distributions as well as changes in the payment profile of RMBS-tranches. We show that the positive effects of a rate freeze, e.g. less foreclosures and a stabilizing housing market, can outweigh the negative effect of lower interest income such that investors might be better off.
Highlights
Starting in mid 2007, rising delinquency and foreclosure rates in the US subprime mortgage market triggered a severe financial crisis which spread around the world
Even though Residential Mortgage Backed Securities (RMBS) tranche investors lose a significant portion of their loss protection, this deterioration may be overcompensated by improvements in mortgage payments due to lower foreclosure rates and a positive feedback effect in the housing market
The discussed interest rate moratorium for subprime mortgages is one option to tackle the current crisis. It is an agreement between two parties - the U.S government and the originating banks - that affects two different third parties: the mortgage debtors and investors in RMBS tranches
Summary
Starting in mid 2007, rising delinquency and foreclosure rates in the US subprime mortgage market triggered a severe financial crisis which spread around the world. As (part of) the mortgage interest payments is used to cover losses that otherwise might hit the rated tranches, RMBS investors lose part of their loss protection following an interest rate freeze They benefit from potentially lower default losses. The risk characteristics of all tranches worsen as compared to the benchmark case which makes severe downgrades necessary as observed in the markets Starting from this crisis scenario we investigate the impact of an interest rate freeze. We conclude that an interest rate freeze on mortgage loans does improve the debtor situation, but might render investors in RMBS tranches better off at the expense of the equity tranche which takes most of the crisis losses.
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