Investors In Mortgage-backed Securities Research Articles

The Cross Section of MBS Returns

ABSTRACTWe present a simple, linear asset pricing model of the cross section of Mortgage‐Backed Security (MBS) returns. MBS earn risk premia as compensation for their exposure to prepayment risk. We measure prepayment risk and estimate risk loadings using prepayment forecasts versus realizations. Estimated loadings on prepayment risk decrease monotonically in securities' coupons relative to the par coupon, consistent with the predicted effect of prepayment on bond value. Prepayment risk appears to be priced by specialized MBS investors. The price of prepayment risk changes sign over time with the sign of a representative MBS investor's exposure to prepayment shocks.

Mortgage Servicing Fees and Servicer Behavior: A Close Examination of the Unexpected Heterogeneity in Servicing Fees

Even though mortgage servicing plays an important role in housing finance, directly affecting millions of homeowners and mortgage-backed security investors, its economics is not well understood, hence making policy formulation and implementation challenging. To fill this gap, we examine the determinants of servicing fees in the non-agency mortgage market and explore how the current compensation structure affects servicer behavior during default remediation. We show that servicer compensation reflects expected mortgage termination risks and depends on whether servicing is outsourced. Furthermore, servicing fees decrease with deal allocation, which suggests economies of scale in servicing, and increase with the intensity of default in servicers' mortgage portfolios. Finally, it appears that issuers' drive to maximize deal returns by auctioning mortgage servicing rights leads to servicing fees determining mortgage modifications and foreclosures, possibly to the detriment of security investors. This is the first study addressing this potentially serious incentive problem in mortgage servicing. The economics of servicing will continue to produce low levels of mortgage renegotiation, despite the Dodd-Frank requirements on servicers.

Multiple Tranches, Information Asymmetry and the Impediments to Mortgage Renegotiation

This paper examines how the creation of asset-backed security tranches disperses ownership of an asset–the pool of mortgages–subsequently impeding renegotiation of the underlying delinquent loans. I describe how multiplicity of tranches worsens the agency problem between a residential mortgage servicer and the mortgage-backed security investors, leading to a sub-optimal rate of loan modification. Using within-deal variation in the number and structure of tranches, I find that delinquent loans in pools collateralizing fewer tranches are more likely to be renegotiated. The results provide evidence for one channel through which mortgage securitization inhibited loan modifications during the Great Recession.

Prepayment Risk and Expected MBS Returns

We present a simple, linear asset pricing model of the cross section of Mortgage-Backed Security (MBS) returns. We measure prepayment risk and estimate security risk loadings using real data on prepayment forecasts vs. realizations. Estimated loadings are monotonic in securities’ coupons relative to the par coupon, as predicted by the model. Prepayment risks appear to be priced by specialized MBS investors. In particular, we find convincing evidence that prepayment risk prices change sign over time with the sign of a representative MBS investor’s exposure to prepayment risk.

Subprime Mortgage Defaults and Credit Default Swaps

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.

An Analysis of Government Guarantees and the Functioning of Asset-Backed Securities Markets

Mortgage securitization has been tried several times in the United States and each time it has failed amid a credit bust. In what is now a familiar recurring history, during the credit boom, underwriting standards are violated and guarantees are inadequately funded; subsequently, defaults increase and investors in mortgage-backed securities attempt to dump their investments. ; We focus on a specific market failure associated with asset-backed securitization and propose a tailored government remedy. Our analysis of loan market equilibriums shows that the additional liquidity provided by securitization may (or may not) lower primary loan rates, but such liquidity comes at a cost. More specifically, if guarantee-sensitive investors doubt the credit quality of asset-backed bonds, significant risk premiums can develop. If a financial crisis ensues, securitization can disappear from the market entirely, leaving banks that originate just the highest quality loans as the only source of credit. This abrupt increase in lending standards can tighten credit, exacerbate asset price declines, and impinge on economic growth. ; We argue that an institutional structure for stemming runs, analogous to the current set up for the Federal Deposit Insurance Corporation, could be deployed to insure pre-specified asset-backed instruments. Such an insurer would likely benefit from the accumulated information and infrastructure that is embodied in Fannie Mae and Freddie Mac. Hence, the provision of federally-backed catastrophic insurance could provide a rationale for restructuring the housing-related GSEs towards a public purpose. Regardless of its institutional structure, a federally-backed catastrophic bond insurer would provide greater financial stability and ensure credit is provided at reasonable cost both in times of prosperity and during downturns. Moreover, the explicit pricing of the government-backed guarantee would mitigate the market distortions that have been created by implicit government guarantees during prosperity.

An Analysis of Government Guarantees and the Functioning of Asset-Backed Securities Markets

Mortgage securitization has been tried several times in the United States and each time it has failed amid a credit bust. In what is now a familiar recurring history, during the credit boom, underwriting standards are violated and guarantees are inadequately funded subsequently, defaults increase and investors in mortgage-backed securities attempt to dump their investments. We focus on a specific market failure associated with asset-backed securitization and propose a tailored government remedy. Our analysis of loan market equilibriums shows that the additional liquidity provided by securitization may (or may not) lower primary loan rates, but such liquidity comes at a cost. More specifically, if guarantee-sensitive investors doubt the credit quality of asset-backed bonds, significant risk premiums can develop. If a financial crisis ensues, securitization can disappear from the market entirely, leaving banks that originate just the highest quality loans as the only source of credit. This abrupt increase in lending standards can tighten credit, exacerbate asset price declines, and impinge on economic growth. We argue that an institutional structure for stemming 'runs,' analogous to the current set up for the Federal Deposit Insurance Corporation, could be deployed to insure pre-specified asset-backed instruments. Such an insurer would likely benefit from the accumulated information and infrastructure that is embodied in Fannie Mae and Freddie Mac. Hence, the provision of federally-backed catastrophic insurance could provide a rationale for restructuring the housing-related GSEs towards a public purpose. Regardless of its institutional structure, a federally-backed catastrophic bond insurer would provide greater financial stability and ensure credit is provided at reasonable cost both in times of prosperity and during downturns. Moreover, the explicit pricing of the government-backed guarantee would mitigate the market distortions that have been created by implicit government guarantees during prosperity.

The Effects of Mortgage Prepayments on M2

Mortgage prepayments can contribute significantly to fluctuations in M2 growth rates. These mortgage prepayment effects are primarily driven by certain rules of mortgage-backed-security (MBS) insurers that require mortgage servicers to hold in M2-type deposits the prepayment proceeds due to MBS investors. This paper provides a methodology for estimating prepayment effects on M2. The effects are estimated separately for refinancing and home sales. The results indicate that excluding the mortgage prepayment effects from M2 produces smoother monthly growth rates. The stability of the relationship between money and GDP as measured by M2 velocity is also increased. Refinancing prepayments account for most of the prepayment effects on M2.

The Effects of Mortgage Prepayments on M2

Mortgage prepayments can contribute significantly to fluctuations in M2 growth rates. These mortgage prepayment effects are primarily driven by certain rules of mortgage-backed-security (MBS) insurers that require mortgage servicers to hold in M2-type deposits the prepayment proceeds due to MBS investors. This paper provides a methodology for estimating prepayment effects on M2. The effects are estimated separately for refinancing and home sales. The results indicate that excluding the mortgage prepayment effects from M2 produces smoother monthly growth rates. The stability of the relationship between money and GDP as measured by M2 velocity is also increased. Refinancing prepayments account for most of the prepayment effects on M2.

Third Party Originators and Mortgage Prepayment Risk: An Agency Problem?

We focus on an agency problem encountered by mortgage lenders and investors in mortgage-backed securities when the underlying collateral is originated by third parties. Third parties, such as mortgage brokers, have economic incentives to encourage borrowers to refinance and, accordingly, their actions may affect asset values. We sketch the principal-agent problem and examine two sets of data. Results support the argument: loans originated by third parties are significantly more likely to prepay after controlling for other known determinants of termination risk. Moreover, third party loans are about three times as sensitive to refinancing incentives, compared to retail loans.