Mortgage-backed Securities Market Research Articles

Did Federal Reserve MBS Holdings Affect More than Asset Prices?

In this paper, we document that mortgage-backed securities (MBS) held by the Federal Reserve exhibit faster principal prepayment rates than MBS held by the rest of the market. Next, we show that this stylized fact persists even when controlling for factors that affect prepayment behavior, and thus determine the MBS that are delivered to the Federal Reserve. After ruling out several potential explanations for this result, we provide evidence that points to an agency problem in the secondary market for MBS, which has not previously been documented, as the most likely explanation for the abnormal prepayment behavior of Federal Reserve-held MBS. This agency problem --- a key feature of the MBS market --- arises when originators of mortgages that underlie the MBS no longer share in the prepayment risk of the securities, thereby increasing incentives to solicit refinancing activity. Therefore, Federal Reserve MBS holdings acquired from originators as a result of large-scale asset purchases can help stimulate economic activity through a so-called "solicited refinancing channel.'' Finally, we provide an estimate of the additional refinancing activity resulting from the solicited refinancing channel in the years after the Federal Reserve's first MBS purchase program, demonstrating that this channel conveyed savings on monthly mortgage payments to homeowners.

Understanding Mortgage Spreads

Most mortgages in the United States are securitized in agency mortgage-backed securities (MBS), and thus the yield spreads on these securities are a key determinant of homeowners’ funding costs. We study the variation in these spreads, over time and across securities, and document that they display a cross-sectional smile pattern with respect to the securities’ coupon rates. We propose non-interest-rate prepayment risk as a candidate driver of the spread variation and present a new pricing model that uses “stripped” MBS prices to identify the contribution of this risk. The pricing model finds the smile to be explained by prepayment risk, while the time-series variation is mostly accounted for by a non-prepayment risk factor that co-moves with MBS supply and credit risk in other fixed-income markets. We then study the MBS market’s response to the Fed’s large-scale asset purchases and use the pricing model to interpret the post-announcement divergence of spreads across MBS.

Anticipating market model failure: Competitive pressure and the mortgage backed securities market

Market models that have worked well for years can suddenly fail dramatically, such as during the financial crisis of the late-2000s. For example, models that assigned credit ratings to mortgage-backed securities (MBS) predicted relative default rates well for decades. It was only in the late-2000s that these models under-predicted defaults by orders of magnitude. Why then? This paper argues that high competitive pressure spurs market participants to change strategies, which can break models. Behavioural research has demonstrated the powerful effect of competition on people's strategies. Indeed, it was in the mid-2000s that competitive pressure spiked among mortgage originators and securitisers, as measured by indicators such as changing market share. Originators and securitisers reacted with a variety of new strategies: creating new mortgage types like no-documentation loans, improving the efficiency of back office processing of mortgages, reducing quality control and, in some cases, committing fraud. Unfortunately, credit rating agencies, secure in their dominant market positions, had no spur to update their models to keep up with the changes. Thus, risk managers could anticipate model failure by monitoring competitive pressure in the relevant markets.

CMBS Risk Precision: Academics to the Rescue

New originations in the U.S. collateralized mortgage-backed securities (CMBS) market sector in 2013 are eclipsing new growth in asset-backed securities (ABS) and residential mortgage-backed securities (RMBS). What is behind this growth? Are investors asserting their preference for a more-tangible asset class that uses a more-fundamental analysis? Or are borrowers better able to sell into a market where the information model is too simple to fully reflect relative risk? The authors propose a method to sharpen CMBS credit analysis by recycling the RMBS information model and leveraging solid academic research findings. This article strives to highlight the wide gap between the broad-based consensus that exists in the literature and the current methods used by practitioners, hopefully to bridge it. The CMBS market has a long and deep history of academic research, one that, however, has yet to bring about a corresponding change in the analytical techniques, assumptions, and information model used by CMBS issuers, rating agencies, and arrangers. The authors show how credit analysis can be made more precise and grounded by reference to default studies by Esaki and Goldman and pioneering analytical work by Varnell, Childs, Riddiough, and Thompson, to mention just a few. Their painstaking results can now form the basis of an analysis more universal to the valuation of CMBS securities across the capital structure, providing greater transparency to already much-maligned investors.

‘Margin Call’: Using Film to Explore Behavioural Aspects of the Financial Crisis

The aim of this article is to show how the critically acclaimed and award winning film Margin Call may be used in business ethics teaching. Set in a fictional investment bank at the dawn of the financial crisis, the film zooms in on the motivations and decision-making of people who had much to lose from the crash of the hitherto very profitable mortgage-backed securities market. The film offers rich material for analysis of behaviours that contributed to the crisis. The article will set out topics for classroom discussion, including the impact of incentives and power structures, contextual factors that distance people from the consequences of their actions, and considerations of how the banking industry may be transformed.

The Design of Subprime Mortgage-backed Securities and Information Insensitivity

What is the securitization process for? What exactly happened in the subprime mortgage-backed securities (MBSs) market from the housing boom to the global financial crisis? To answer these questions, I use a novel hand-collected dataset of subprime MBSs issued between 2004 and 2007, which includes a detailed description of underlying mortgage characteristics and deal structures. This paper studies the purpose of the securitization process in the context of the subprime MBS market as a trigger of the global financial crisis. I find that the credit enhancements reflect the credit risks of underlying collaterals, thus ex-ante qualities of AAA subprime MBS tranches had not been deteriorated. In addition, the AAA tranche spreads are mostly explained by the bond market conditions and uncorrelated with the credit risk of collateral. This results suggest that market participants designed and priced the subprime MBSs in the way that the AAA tranche could be information insensitive. In other words, the securitization process makes it possible that market participants have less incentive to learn about the underlying collateral information.

The Price Effects of Fannie Mae's Liquidity Provision Activities within the Secondary Market for Mortgage Backed Securities

In this paper, I find a charter which allows Government Sponsored Enterprises (Fannie Mae) that guarantee mortgage backed securities (MBS) to act as liquidity providers within secondary mortgage markets is beneficial for MBS prices and dealers’ transaction costs. I also demonstrate that the price effects of a charter that allows liquidity provision activities, but confers a financing disadvantage on an MBS guarantor (Fannie Mae’s charter) are comparable to the price effects of a charter that confers a financing advantage on an MBS guarantor, but restricts liquidity provision activities (Ginnie Mae’s charter). An important implication of my findings is that a systematic decrease in dealers' inventory balances can be indicative of either an increase in confidence in a liquidity provider's ability to satisfy demand or supply imbalances, or an increase in the systematic risk of mortgage backed securities.

TBA Trading and Liquidity in the Agency MBS Market

1. INTRODUCTION The U.S. residential mortgage market has experienced significant turmoil recent years, leading to important shifts the way mortgages are funded. Mortgage securitization by private financial institutions declined to negligible levels during the financial crisis that began August 2007, and remains low today. In contrast, throughout the crisis there continued to be significant ongoing securitization the agency mortgage-backed-securities (MBS) market, consisting of MBS with a credit guarantee by Fannie Mae, Freddie Mac, or Ginnie Mae. (1) Agency MBS the amount of $2.89 trillion were issued 2008 and 2009, but no non-agency securitizations of new loans occurred during this period. The outstanding stock of agency MBS also increased significantly during the crisis period, from $3.99 trillion at June 2007 to $5.27 trillion by December 2009. (2) A key distinguishing feature of agency MBS is that each bond either carries an explicit government credit guarantee or is perceived to carry an implicit one, protecting investors from credit losses case of defaults on the underlying mortgages. (3) This government backing has been the subject of a long-running academic and political debate. A second, less widely recognized feature is the existence of a liquid forward market for trading agency MBS, out to a horizon of several months. (4) The liquidity of this market improves market functioning and helps mortgage lenders manage risk, since it allows them to lock in sale prices for new loans as, or even before, those mortgages are originated. More than 90 percent of agency MBS trading volume occurs this forward market, which is known as the TBA (to-be-announced) market. In a TBA trade, the seller of MBS agrees to a sale price, but does not specify which particular securities will be delivered to the buyer on settlement day. Instead, only a few basic characteristics of the securities are agreed upon, such as the coupon rate, the issuer, and the approximate face value of the bonds to be delivered. While the agency MBS market consists of thousands of heterogeneous MBS pools backed by millions of individual mortgages, the TBA trading convention allows trading to be concentrated only a small number of liquid forward contracts. TBA prices, which are observable to market participants, also serve as the basis for pricing and hedging a variety of other MBS, which The main goal of this article is to describe the basic features and mechanics of the TBA market, and to review recent legislative changes that have affected the types of mortgages eligible for TBA trading. The article also presents some preliminary evidence suggesting that the liquidity benefits associated with TBA eligibility increase MBS prices and reduce mortgage interest rates. Our analysis exploits changes legislation to help disentangle the effects of TBA eligibility from other characteristics of agency MBS. In particular, we study pricing for mortgages that became eligible for agency MBS securitization through legislation 2008, but that were ruled ineligible to be delivered to settle TBA trades. We show that MBS backed by super-conforming mortgages trade at a persistent price discount the secondary market, and also that interest rates on such loans are correspondingly higher the primary mortgage market. Preliminary evidence suggests that these stylized facts are not fully explained by differences prepayment risk. We interpret our estimates to suggest that the liquidity benefits of TBA eligibility may be of the order of 10 to 25 basis points on average 2009 and 2010, and are larger during periods of greater market stress. Our institutional discussion and empirical results support the view that the TBA market serves a valuable role the mortgage finance system. This finding suggests that evaluations of proposed reforms to U.S. housing finance should take into account potential effects of those reforms on the operation of the TBA market and its liquidity. …

Ratings Arbitrage and Structured Products

An apparent breakdown of the credit rating process for structured products is widely believed to have played a major role in the run-up and subsequent collapse of the market for mortgage-backed securities. In this article, Hull and White observe that the ratings criteria used by two of the ratings agencies (Standard and Poor’s and Fitch) are supposed to reflect the probability of default but not the possible severity of the investor’s loss in a default, which introduces anomalies into the rating process. For example, diversification of a credit portfolio across issuers with equal credit quality increases the chance of a default by one of them—thus lowering the rating on the portfolio—even though the loss is reduced if there is a default. The default-risk-only criterion is shown to fail the requirements for a risk measure to be “coherent,” which means that the structuring process allows for profitable credit arbitrage. <b>TOPICS:</b>Derivatives, MBS and residential mortgage loans, financial crises and financial market history

Quantifying Adverse Selection in the Commercial Mortgage-Backed Security Market

A commercial mortgage-backed security (CMBS) is a claim on future returns to a bundle of loans. Empirically, loans that are securitized “in-house” -- when the loan originator is vertically integrated with the issuer of the CMBS -- outperform loans securitized by unaffiliated issuers. I examine the extent to which this difference stems from ex ante selection versus the effect of vertical integration on ex post returns, such as due to moral hazard. In my model, CMBS issuers first choose a portfolio of loans, then issue securities backed by these loans that they sell to uninformed investors in a signaling game. To distinguish between ex ante selection and effects on ex post returns, I exploit exogenous variation in the set of feasible matches between issuers and loans and heterogeneity in the match values due to portfolio diversification effects. The better performance of in-house loans can be entirely explained by ex post returns -- on net, they actually have somewhat worse unobserved ex ante quality than non-in-house loans. The pricing of CMBS suggests that investors are aware of the phenomenon.

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.

Design of Financial Securities: Empirical Evidence from Private-Label RMBS Deals

We study the key drivers of security design in the residential mortgage-backed security (RMBS) market during the run-up to the subprime mortgage crisis. We show that deals with a higher level of equity tranche have a significantly lower delinquency rate conditional on observable loan characteristics. The effect is concentrated within pools with a higher likelihood of asymmetric information between deal sponsors and potential buyers of the securities. Further, securities that are sold from high-equity-tranche deals command higher prices conditional on their credit ratings. Overall, our results show that the goal of security design in this market was not only to exploit regulatory arbitrage, but also to mitigate information frictions that were pervasive in this market.

CMBS Overview

The CMBS panel held on October 18, 2011, focused on recent developments in the Commercial Mortgage-Backed Securities (CMBS) market. The panelists addressed how the most recent CMBS deals compare with CMBS deals that were issued before the credit crisis in 2008/2009 and with the CMBS deals that restarted the CMBS market after the credit crisis. The expectation is that the market will continue to grow in 2012, although it will be buffeted by European headwinds. Macro-induced volatility has cheapened the sector even while the credit fundamentals remain sound at the top of the capital stack, creating investment opportunities. <b>TOPICS:</b>MBS and residential mortgage loans, CMBS and commercial mortgage loans

The Future of Housing Finance and the GSEs

This presentation covers the size of the U.S. mortgage market, the U.S. government’s role in that market, the bubble and burst in housing prices, current trends in residential mortgage delinquencies, the disproportionate share of delinquent mortgages securitized into private label securities, recommended ways to prevent foreclosures, suggestions to rebuild confidence in the residential securitization market, current challenges for mortgage servicers, a possible future role and structure for government-sponsored enterprises (GSEs), and recommended features of an improved mortgage-backed securities market.

Housing Finance in Central America: What is Holding it Back?

This paper surveys housing finance in Costa Rica, El Salvador and Panama. The development of a secondary mortgage-backed securities market in Costa Rica is very limited despite a broad legal framework, while in El Salvador it is nonexistent and in Panama has not grown due to high liquidity. In Costa Rica's subsidy policy, core institutions responsible for housing policy act as facilitators of private agents. This contrasts with the dispersion of policy and institutional efforts identified in Panama and El Salvador. Government subsidies are especially directed to households where more of 90 percent of the housing deficit is concentrated. A solution based on public budgets is not sustainable, requiring an active role of the private housing finance sector. Increasing the purchase capacity of families and reducing the cost of financing are necessary conditions to reduce housing deficits.

The U.S. Financial System in 2011: How Will Sufficient Credit Be Provided?

This paper uses Flow of Funds data on the level of net new credit extension to construct a bird’s-eye view of what the financial market landscape might look like once the turmoil subsides and the economy has begun to recover. The paper targets two related questions: (1) How much credit must be extended in order to return the economy to its long-run trend growth? (2) What roles will the major credit providers likely play in that process? The mix of sources supplying credit for the home mortgage, consumer, and nonfinancial business sector markets is different, and so we consider each of those markets separately. We focus on the roles of banks, traditional nonbank credit providers (such as finance companies and pension funds), the corporate bond and commercial paper markets, and structured finance, including government-sponsored enterprise (GSE) mortgage-backed securities (MBS) issuance, consumer (i.e., nonmortgage) asset-backed securities (ABS) issuance, and the commercial mortgage-backed securities (CMBS) market. As a reasonable assumption as to how the credit market may develop we start by positing a “baseline” scenario under which banks return to their long-run trend level of financing for home mortgage, consumer, and business sector borrowing. We then examine the extent to which other major providers of credit are likely to fill the remaining demand for credit. We consider what would happen if various of these credit providers were unable to meet the credit supply role asked of them in order to fulfill credit demand. We conclude that the revival of structured finance is crucial for home mortgage, consumer, and business sector credit provision if sharp adjustments in the cost of credit and major structural adjustments in credit markets are to be avoided. Specifically: (1) in the home mortgage market, GSE’s sales of MBS sufficient to support about half of borrowers’ credit needs are required for banks and private-label securitizers to operate at normal levels; and at least a modest role for private label MBS issuance is probably necessary to ensure adequate mortgage credit availability at a normal interest cost, (2) for consumer borrowing, without a substantial revival of the ABS market, banks and nonbank credit providers would not likely make up for the resultant shortfall without a sharp rise in the cost of consumer credit, and (3) for business sector credit, the re-emergence of the CMBS market is likely essential for adequate provision of commercial mortgage credit since, in the absence of large changes in the price of credit, banks are unlikely to make up for a large shortfall of CMBS-supported business sector credit extension. In contrast, banks and other credit channels likely would replace a credit shortfall resulting from a moribund commercial paper market without an undue rise in the cost of business credit.

Securitization Down Under Looking Up

The role and significance of securitization in Australia’s financial system is that it provides an element of competition and choice for consumers, particularly home loan borrowers, which defrays to a degree the dominant market presence of the four major banks. The strength of Australia’s prime residential mortgage-backed securities (RMBS) market is underpinned by conservative products, full recourse to the borrower, and non-deductibility of mortgage interest. Current challenges for the Australian securitization market include rebuilding the sustainable base of global investors it had before the financial crisis and changes to the credit rating agencies’ rating criteria. Optimism stems from the central bank’s acceptance of RMBS as security for its secured liquidity facility under Basel III provisions and increased domestic funds’ allocations toward domestic fixed-income securities.

Lending sociodynamics and economic instability

We show how the dynamics of economic instability and financial crises articulated by Keynes in the General Theory and developed by Minsky as the Financial Instability Hypothesis can be formalized using Weidlich’s sociodynamics of opinion formation. The model addresses both the lending sentiment of a lender in isolation as well as the impact on that lending sentiment of the behavior of other lenders. The risk associated with lending is incorporated through a stochastic treatment of loan dynamics that treats prepayment and default as competing risks. With this model we are able to generate endogenously the rapid changes in lending opinion that attend slow changes in lending profitability and find these dynamics to be consistent with the rise and collapse of the non-Agency mortgage-backed securities market in 2007/2008. As the parameters of this model correspond to well-known phenomena in cognitive and social psychology, we can both explain why economic instability has proved robust to advances in risk measurement and suggest how policy for reducing economic instability might be formulated in an experimentally sound manner.

The Origins and Evolution of the Market for Mortgage-Backed Securities

The first mortgage-backed security (MBS) was issued in 1968. Thereafter, the MBS market grew rapidly with outstanding issuances exceeding $9 trillion by 2010. The growth in the MBS market was accompanied by numerous innovations such as collateralized mortgage obligations (CMOs) and the emergence of private label alternatives to MBS issued by government-sponsored entities. We trace the evolution of the MBS market and we review debates surrounding such questions as whether the MBS market has reduced the cost of housing finance, whether the MBS market is a market for lemons, and what role, if any, MBS played in the run-up and subsequent decline of home prices during the decade of the 2000s. We also detail the evolution of models for MBS valuation as developed by academics and practitioners.

The Origins and Evolution of the Market for Mortgage-Backed Securities

The first mortgage backed security (MBS) was issued in 1968. Thereafter, the MBS market grew rapidly with outstanding issuance's exceeding $9 trillion by 2010. The growth in the MBS market was accompanied by numerous innovations such as the collateralized mortgage obligations (CMOs) and the emergence of private label alternatives to MBS issued by government sponsored entities. We trace the evolution of the MBS market and we review debates surrounding such questions as whether the MBS market has reduced the cost of housing finance, whether the MBS market is a market for lemons, and what role, if any, MBS played in the run-up and subsequent decline of home prices during the decade of the 2000s. We also detail the evolution of models for MBS valuation as developed by academics and practitioners.