Identifying Risk Factors Underlying the U.S. Subprime Mortgage-Backed Securities Market

Abstract

The devastating credit crunch and subsequent liquidity freeze of 2007–2008 plunged the global financial market into one of its worst crises ever experienced. It is now clear that subprime mortgage-backed securities lay at the heart of this catastrophe and that the risk underlying these securities was vastly underestimated. This paper examines this risk by performing principal component analysis, OLS regression analysis and rolling regression analysis on ABX.HE Indexes data. The results of the principal component analysis results show that the main principal component falls in importance with each new vintage issuance, suggesting that there were other unobserved factors contributing to the variation in the data. The OLS regression analysis also suggests that other factors were coming into play as the crisis evolved and the rolling regression analysis allows us to link these changes to important events in the crisis, namely the onset of the liquidity crisis in September 2008. Overall the results indicate that these are assets are heterogeneous in nature, and not simply a continuation of the previous issuance.