Subprime Mortgage-backed Securities Research Articles

U.S. Sub-Prime Crisis: Origin and Causes

The purpose of this paper is to explain the boom and bust of the housing market in the U.S. and how the sub-prime mortgages gave birth to new securitized products in the global economy. The majority of the researches conducted previously to explore the reason for the sub-prime crisis and its impact on the volatility on the stock market of the home country (U.S.) and the other developing countries. This paper also contributes to the literature about causes, timeline, and major crisis events during the crisis period. The literature on the Subprime crisis revealed many causes of the Sub-prime crisis. These were Imprudent Mortgage Lending, Housing Bubble, Global Imbalances, Securitization, Lack of Transparency and Accountability in Mortgage Finance, Rating Agencies- The credit rating agencies gave AAA ratings to numerous issues of subprime mortgage-backed securities, many of which were subsequently downgraded to junk status. Deregulatory Legislation, Government-Mandated Sub-prime Lending, Complexity of certain financial instruments, Failure of Risk Management Systems, Excessive Leverage and Relaxed Regulation of Leverage were the most discussed reasons of Subprime Crisis.

Subprime borrowers, securitization and the transmission of business cycles

AbstractA growing literature (e.g., Jaffee et al. 2009, Acharya and Schnabl 2009) argues that securitization improves financial stability if the securitized assets are held by capital market participants, rather than financial intermediaries. I construct a quantitative macroeconomic model with a novel specification for mortgage‐backed securities (MBS) to evaluate this claim. My findings suggest that the existence of the securitization market stabilizes the economy under the condition that financial intermediaries do not engage in the acquisition of securitized assets. In the presence of large negative housing preference shocks, the drop in output in the first year after the shock is halved if subprime MBS are purchased by non‐financial agents rather than held by banks.

The effect of large investors on asset quality: Evidence from subprime mortgage securities

Fannie Mae and Freddie Mac (the GSEs), the dominant investors in subprime mortgage-backed securities before the 2008 crisis, substantively affected collateral composition in this market. Mortgages included in securities designed for the GSEs performed better than those backing other securities in the same deals, holding observable risk constant. Consistent with the transmission of private information, these effects are concentrated in low-documentation loans and for issuers that were highly dependent on the GSEs and were corporate affiliates of the mortgage originators. Additional analysis of yield spreads shows that these performance differences were not reflected in prices.

ANALYZING CONTAGION FROM THE U.S. SUBPRIME MORTGAGE-BACKED SECURITIES MARKET

This paper analyzes contagion from the U.S. subprime mortgage-backed securities market, represented by the ABX.HE indices, to several fixed income, equity and volatility markets in line with seminal literature on the subject. We analyze ‘spliced’ data set constructed in line with the literature, along with two traded ABX.HE indexes. A VAR framework is employed, firstly to extend existing analysis to include 2009, and then to analyze two traded indexes. In order to test the sensitivity of these results ABX returns are then included as an eighth endogenous variable in the VAR. Principal component analysis is employed to reduce the dimensionality of the data. The main principal component obtained is then included as an exogenous variable in the VAR framework and the sensitivity of these results is tested by including this principal component as an eighth endogenous variable. The results indicate evidence of contagion from the ABX indexes during the crisis of 2007-2009 but the source and intensity of this contagion varies across indexes. This highlights the differences across the three ABX data sets analyzed and suggests that splicing the ABX index may impact the results obtained. It also provides evidence that the traded ABX indexes are heterogeneous assets with varying sensitivities to risk factors during the crisis.

Subprime Borrowers, Securitization and the Transmission of Business Cycles

A growing literature (i.e. Jaffee, Lynch, Richardson, and Van Nieuwerburgh, 2009, Acharya and Schnabl, 2009) argues that securitization improves financial stability if the securitized assets are held by capital market participants, rather than financial intermediaries. I construct a quantitative macroeconomic model with a novel specification for mortgage-backed securities (MBS) to evaluate this claim for subprime securitization during the Great Recession. I find that output in the U.S. would have dropped by only about a third and house prices by only a half of what we actually observed, if subprime MBS had been purchased by non-financial agents, rather than held by banks. This is because banks are subject to capital requirements and if MBS remain within the banking system, the fall in their value puts a strain on banks’ balance sheets. The subsequent deleveraging amplifies business cycles. My findings suggest that the existence of the securitization market stabilizes the economy under the condition that financial intermediaries do not engage in the acquisition of securitized assets.

The role of U.S. subprime mortgage-backed assets in propagating the crisis: Contagion or interdependence?

Though relatively small, the subprime mortgage-backed securities market is often identified as the source of the crisis that swept through the U.S. financial system from 2007 onwards. We investigate if its role in the propagation of the crisis was due to contagion or interdependence. Using a Markov-switching VAR with time-varying transition probabilities, we analyse the transmission of shocks across the financial system. We find little evidence of asset correlation changes between normal and crisis regimes and those that do occur are predominantly associated with liquidity variables. Otherwise, relationships are stable across market conditions, implying that the U.S. financial crisis was due to cross-market interdependencies rather than contagion. There is limited evidence that the deteriorating quality of the underlying assets can explain the transition from ‘normal’ market conditions to a high-volatility regime, although this is not consistent across model specifications.

The Effect of Large Investors on Asset Quality: Evidence from Subprime Mortgage Securities

The government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac—the dominant investors in subprime mortgage-backed securities before the 2008 crisis—substantively affected collateral composition in this market. Mortgages included in securities designed for the GSEs performed better than those backing other securities in the same deals, holding observable risk constant. Consistent with the transmission of private information, these effects are concentrated in low-documentation loans and for issuers that were highly dependent on the GSEs and were corporate affiliates of the mortgage originators. Additional analysis of yield spreads shows that these performance differences were not reflected in prices.

Discretionary ratings and the pricing of subprime mortgage-backed securities

Using a dataset of Home Equity Loan securities issued up to June 2007 and rated by Moody’s and/or S&P, this paper investigates how discretionary ratings are priced by the market. To this end, a measure of relative rating inflation (Rating Bias) observable at issuance is proposed. The way Rating Bias is priced changes significantly between Investment Grade (IG) and Speculative Grade (SG) securities. Rating Bias is only partially discounted for IG tranches, whereas it is correctly priced for SG ones. Less sophisticated institutional investors are often restrained from investing in securities rated lower than triple-A, double-A or A; however, these alternative thresholds do not appear to play a role as relevant as that of the IG–SG boundary. Rating Bias is also found to have an asymmetric impact on spreads: the relevance of actual over expected ratings is greater for tranches receiving evaluations that are higher (rather than lower) than expected. Taken together, these pieces of empirical evidence point toward ratings-based regulation as an important explanation for the observed mispricing of structured finance products.

Discretionary Ratings and the Pricing of Subprime Mortgage-Backed Securities

Using a dataset of Home Equity Loan securities issued up to June 2007 and rated by Moody’s and/or SP however, these alternative thresholds do not appear to play a role as relevant as that of the IG-SG boundary. Rating Bias is also found to have an asymmetric impact on spreads: the relevance of actual over expected ratings is greater for tranches receiving evaluations that are higher (rather than lower) than expected. Taken together, these pieces of empirical evidence point toward ratings-based regulation as an important explanation for the observed mispricing of structured finance products. JEL classification: G01, G14, G24, G38

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.

Knowledge production in financial markets: credit default swaps, the ABX and the subprime crisis

In 2008, the solvency of many of the world's leading banks came to hinge on valuations of portfolios of subprime mortgage-backed securities. This paper examines the ABX, a crucial new market (set up in January 2006) widely used as a guide to these valuations. The paper outlines the origins of the ABX, discusses the sometimes fiercely contested process of the standardization of the credit default swaps that underlay it, and outlines how the ABX rendered the subprime crisis visible to financial markets. Credit default swaps and the ABX are traded in a specific form of market that I call ‘the canonical mechanism’. Because canonical-mechanism markets are well regarded, it is easy when analysing them to slip into functionalism. Accordingly, this paper emphasizes the contested and sometimes precarious nature of canonical-mechanism markets, discussing disputes over how to standardize financial instruments, over the ‘fairness’ of prices and over the dependability of those prices as indicators of the economic value of financial instruments. Canonical-mechanism markets, the clashes of interests they can involve, the material ways in which prices are generated and circulated within them and their limits as generators of knowledge all need to be researched in depth.

Assessing Risk on Subprime Mortgage Backed Securities: Did Credit Rating Agencies Misrepresent Risk to Investors?

The Securities and Exchange Commission (SEC) has asked whether credit rating agencies (CRA) committed fraud by misleading investors with respect to the default risk on mortgage backed securities (MBS). This paper argues that, to the detriment of investors, the CRA did not incorporate information available to securitizers in their ratings of subprime mortgage backed securities. A test of this proposition utilizes data on CRA ratings of 32 Goldman Sachs MBS issued in 2005-2007 and Moody’s Investor Services projections of loss for these mortgage pools. The percent of principal balances rated triple-A is relatively constant over this period. In contrast, projected losses increase substantially for 2006-2007 MBS issues. A Goldman Sachs presentation to its Board highlights factors that enhanced the risk of default in 2006-2007. Review of a select sample of 2006-2007 MBS prospectuses contain disclosures of market, originator and mortgage characteristics that the securitizer associates with an increased risk of default. These disclosures suggest that the risk of default increased step wise beginning in 2006. While the same information was available to the CRA, their credit risk ratings did not incorporate this information and remained flat. Should the SEC obtain data on the near term performance of these MBS they would be able to establish if this divergence in risk assessment was substantial and if the CRA chose to support their clients to the detriment of MBS investors.

Credit Ratings and Security Prices in the Subprime MBS Market

We present and discuss preliminary evidence suggesting that credit ratings significantly influenced prices for subprime mortgage-backed securities issued in the period leading up to the recent financial crisis. Ratings are closely correlated with prices even controlling for a rich set of security- and loan-level controls. This incremental variation in ratings has much less predictive power for security defaults, however, based on findings to date from our ongoing research, suggesting prices were excessively sensitive to ratings relative to their informational content.

Rating Alignment, Rating Shopping and Reputation of Credit Rating Agencies: Evidence from the Subprime Crisis

This paper compares conflict of interest incentives and reputational concerns of credit rating agencies (CRAs) in the context of the subprime crisis. We argue that, during up-market periods, ratings levels are affected by both a strong tendency for alignment across CRAs and ratings “shopping” by issuers, while, during periods of economic slowdown, these distortions disappear since CRAs are then more concerned about their long-run reputation. We test our hypotheses by analyzing the gap between Moodys and S&Ps ratings on US residential, subprime mortgage-backed securities before and after the 2007 crisis. Overall, our results show a clear reduction in ratings alignment. Moreover, we find strong evidence that harsher downgrades came from S&P, which had higher ratings before the crisis, and that the gap reduction is strongly correlated with the rating gap before the crisis. We interpret this as evidence that CRAs try to “reverse the gap”, to reduce the impact on their (relative) reputation. Finally, we find that harsher downgrades tend to occur for securities not jointly rated and that the relation between downgrades and initial rating is significantly different across the two agencies, this being consistent with the rating shopping hypothesis.

CDO market implosion and the pricing of subprime mortgage-backed securities

We evaluate the effects of CDO issuance on the pricing of subprime residential mortgage-backed securities. Upon controlling for mortgage option values and other well-established determinants of credit spreads, GMM results indicate that the emergence and rapid capitalization of the subprime-backed CDO market was associated with a significant tightening of subprime MBS–Treasury yield spreads. Results of VAR and other robustness tests serve to corroborate the findings. Dynamic simulation based on the impulse response function estimates indicates substantial subprime MBS spread widening in the wake of the recent implosion in the CDO market. Research findings suggest the importance of supply/demand shocks associated with innovations in derivative securities markets to the pricing of securitized subprime debt.

An Overview of the Linkages of the Global Financial Crisis to Production Agriculture

The credit crisis has substantially impacted global financial and commodity markets. What started as a crisis in a relatively small part of the mortgage credit market in the subprime space has spilled over into the larger U.S. hous ing market and eventually led to a freezing of global credit markets. The Dow Jones Indus trial Average exceeded 14,000 in October 2007 and has since fallen to below 6,500 in March 2009?a decline of over 54%. The Chicago Board Options Exchange Volatility Index (a measure of equity market volatility implied from options on the S&P 500 index) has ex ploded to levels that are nearly twice the levels seen during the previous crises in capital mar kets, including the Long-Term Capital Man agement crisis, the 9/11 attacks, and the Thai Baht crisis just to name a few. The funding mar kets were disrupted as never before, and the plethora of policy measures taken by govern ments and central bankers globally have yet to restore them to precrisis levels. The unprece dented volatility and uncertainty has certainly disrupted financial markets and shaken confi dence among global financial institutions. Production agriculture has certainly not been immune to the crisis. A direct impact of the credit crisis has been on global growth. This has manifested in significant contraction in aggregate demand, leading into a commod ity price recession. Declines in farm income and farmland values may be a likely conse quence of the commodity price declines. The primary objectives of this article are to provide an overview of the impact and costs of the credit crisis and to measure linkages to agricultural producers, lenders, and agribusi nesses. The two subsequent articles in this session provide details on the agricultural institutions lending to agriculture and the enhanced risk management strategies that producers and lenders will have to employ. In this article, the broad outlines of the man ifestation of the crisis are illustrated through key credit market indicators. Key events in the chronology of the crisis and how the credit malaise that first came to notice in the U.S. subprime mortgage-backed securities market and subsequently spread to other sectors are discussed. The tally of the write-downs and losses that have been realized thus far across

Fundamental, Flight-to-Quality, and Flight-to-Liquidity Components in Subprime Mortgage-Backed Security Returns

A growing body of theoretical and empirical literature addresses the timely issue of flight-to-quality and flight-to-liquidity episodes in financial markets. Recent returns on the various credit tranches of the ABX, a widely used derivative that provides exposure to an index of subprime mortgage-backed securities, are ideal for studying the interplay among fundamental news, flights-to-quality, and flights-to-liquidity. By interpreting principal component loadings and regressing the estimated components on financial and economic variables, this article offers evidence that, during the subprime crisis, ABX returns have been primarily determined by 1) a large first component that proxies for mostly fundamental information and 2) a still sizeable but smaller second component that is unrelated to fundamentals and proxies for flight-to-quality behavior.The author then interprets the two components in a portfolio context after adjusting for economic leverage. Finally, the author shows that subprime mortgage-backed securities are still in the midst of a sizeable flight-to-quality episode and that a portfolio that is perfectly negatively correlated with the second principal component should 1) exhibit abnormal profits when the flight-to-quality effect dissipates and 2) be ex-ante hedged against fundamental risk. <b>TOPICS:</b>MBS and residential mortgage loans, credit default swaps, statistical methods, financial crises and financial market history

Systemic Risk in the Financial Sector: An Analysis of the Subprime-Mortgage Financial Crisis

The paper analyses the causes of the current crisis of the global financial system, with particular emphasis on the systemic elements that turned the crisis of subprime mortgage-backed securities in the United States, a small part of the overall system, into a worldwide crisis. The first half of the paper explains the role of mortgage securitization as a mechanism for allocating risks from real estate investments and discusses what has gone wrong and why in the implementation of this mechanism in the United States. The second half of the paper discusses the incidence of systemic risk in the crisis. Two elements of systemic risk are identified. First, there was excessive maturity transformation through conduits and structured-investment vehicles (SIVs); when this broke down in August 2007, the overhang of asset-backed securities that had been held by these vehicles put significant additional downward pressure on securities prices. Second, as the financial system adjusted to the recognition of delinquencies and defaults in US mortgages and to the breakdown of maturity transformation of conduits and SIVs, the interplay of market malfunctioning or even breakdown, fair value accounting and the insufficiency of equity capital at financial institutions, and, finally, systemic effects of prudential regulation created a detrimental downward spiral in the overall financial system. The paper argues that these developments have not only been caused by identifiably faulty decisions, but also by flaws in financial system architecture. In thinking about regulatory reform, one must therefore go beyond considerations of individual incentives and supervision and pay attention to issues of systemic interdependence and transparency.

Valuation of Mortgage-Backed Securities: A Portfolio Credit Derivatives Approach

Non-agency mortgage-backed securities (MBS) are typically priced and traded on discounted cashflow basis where a cashflow projection is made under a prepayment and default scenario and discounted with a discount margin (DM) that supposedly measures credit risk. Whilest simple and intuitive to traditional buy-and-hold investor base, it quickly became clear that DM was not effective for pricing and risk management, when mortgage credit rapidly grew out of usually mild credit environment and more sophisticated participants entered into the market. In particular, synthetic players' push for standardization of CDS on ABS and index products (ABX and CMBX) started to demand pricing consistency across cash and synthetics. In this paper we advocate application of portfolio credit derivative no arbitrage pricing framework to mortgage securitization products and their derivatives. To demonstrate we focus on the first toxic out of the Pandora's box into the financial system -- subprime MBS. We develop an amortizing mortgage loan model with competing arrival of random prepayment and default events following reduced form modeling of corporate default. Loan prepayment correlation, default correlation, and cross correlation can be built drawing into vast literature of corporate default correlation modeling. As both prepayment and default depend on house price appreciation and interest rate, we introduce a prepayment and default factor copula (Gaussian) to statically model these two factors. Analysis of recent vintage subprime deal structure reveals a near sequential pay waterfall which allows semi-analytical pricing of MBS. Calibration to ABX.HE benchmark is satisfactory and pricing of bespoke ABS off the index not only offers fair value data points when there is no market but also an innovative way to assess relative values. ABS CDO and TABX can be consistently priced with underlying ABS and the model naturally extends to CMBS/CMBX/CRE CDO and CLO/LCDX.

Editor's Letter

1. Henry A Davis We begin with a section on subprime mortgage-backed securities and the financial crisis, as we have for the past six quarterly issues. Joshua Rosner points to the shortcomings he sees in the Nationally Recognized Statistical Rating Organizations’ (NRSROs’) approach toward