Abstract
We examine whether the predictive power of initial yield spreads of mortgage-backed securities (MBS) vary with the financial cycle. Using a cross-country sample of 4203 MBS, we find that initial yield spreads of MBS incorporate more information than credit ratings and predict future downgrades, even after conditioning on initial credit ratings. Predictive power of spreads is higher during credit and housing bubbles and for the least risky AAA-rated MBS. We find that initial yield spreads capture the magnitude of rating downgrades, especially during asset bubble periods. As a novel approach in this literature, we also utilise machine learning techniques (regression trees, naïve Bayes, support vector machines and random forests) to confirm our results.
Highlights
Demand for mortgage-backed securities (MBS) climbed in the years leading to the 2007–2009 Great Financial Crisis (GFC) as these bonds offered higher yields and required lower capital charges
We investigate whether the predictive power of initial MBS yield spreads varies with the financial cycle,2 a question that has not been addressed in the existing literature
We find that initial yield spreads are powerful predictors of future performance for the lowest quality Residential MBS (RMBS), especially when the estimations are run with the housing bubble variable
Summary
Demand for mortgage-backed securities (MBS) climbed in the years leading to the 2007–2009 Great Financial Crisis (GFC) as these bonds offered higher yields and required lower capital charges. Deku et al (2019) find that engaging reputable trustees in securitization transactions led to lower spreads, and trustees’ reputation became more important when risk assessment was more challenging due to several layers of misaligned incentives in the securitisation chain Overall, this strand of the literature shows that investors attempted to incorporate the potential costs of misaligned interests beyond the informative content of ratings into initial MBS prices. The existing literature finds that yield spreads are reliable predictors of future performance, and credit ratings do not seem to capture all the risks embedded in MBS (Adelino 2009; He et al 2016) He et al (2016) reports that the predictive power of yields for future losses was stronger during the period of 2004–2006 (i.e. the pre-crisis period), when the US market was at its peak. We contribute to the literature by testing the predictive power of initial MBS yield spreads, and its possible variation with the financial cycle, in the European securitization market. According to data published by Securities Industry and Financial Markets Association (SIFMA), issuing banks were only able to place 36% of all issuances between July and December of 2007, 13% in 2008 and only 6% in 2009
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