Subprime Mortgage Defaults and Credit Default Swaps

Abstract

This paper provides the first empirical investigation of the influence of credit default swaps (CDS) on the surge in subprime mortgage defaults, which is widely believed to be a driving force in the 2008/2009 financial crisis. In the years just before the 2008/2009 financial crisis, private mortgage securitizers were eager to supply world-wide demand for trillions of dollars of “highly-rated” mortgage-backed securities (MBS) created from pools of subprime mortgage loans. The net effect was that lenders offered more and more loans to higher-risk borrowers which inevitably drove much higher subprime mortgage defaults. We argue that this chain of events was in part fueled by the simultaneous increase in the market for credit default swaps. In particular, issuers and investors in MBS could hedge the credit risk of the subprime loans underlying these securities with CDS contracts. In this way, MBS market participants could limit their exposure to the risk of securitized loans, which in turn stimulated greater demand for riskier loans, which were eagerly supplied by mortgage loan originators who earned lucrative fees. This line of reasoning therefore suggests that CDS contracts insuring MBS backed by subprime loans had a direct effect on the surge in subprime mortgage defaults. We test this prediction using a large sample of privately securitized subprime mortgages that were originated during the period from 2003 to 2007. We find that CDS coverage increases the probability of subprime loan delinquency by 3.2% to 5.4%, or an additional $9.9 billion to $13.3 billion in delinquent loan value. The negative effect of CDS coverage on loan performance is similar across loan types, and is robust to correction for endogeneity of CDS coverage and to alternative definitions of concurrent CDS coverage. Taken together, we find strong evidence that CDS coverage had a significant effect on the subprime mortgage crisis.