Identifying Risk Factors Underlying the U.S. Subprime Mortgage-Backed Securities Market

Abstract

The devastating credit crunch and subsequent liquidity freeze of 2007–2008 plunged the global financial market into one of its worst crises ever experienced. It is now clear that subprime mortgage-backed securities lay at the heart of this catastrophe and that the risk underlying these securities was vastly underestimated. This paper examines this risk by performing principal component analysis, OLS regression analysis and rolling regression analysis on ABX.HE Indexes data. The results of the principal component analysis results show that the main principal component falls in importance with each new vintage issuance, suggesting that there were other unobserved factors contributing to the variation in the data. The OLS regression analysis also suggests that other factors were coming into play as the crisis evolved and the rolling regression analysis allows us to link these changes to important events in the crisis, namely the onset of the liquidity crisis in September 2008. Overall the results indicate that these are assets are heterogeneous in nature, and not simply a continuation of the previous issuance.

Appendix: The ABX.HE Indexes

Credit derivatives markets were experiencing rapid growth in the mid-2000s (Hull 2009). The notional amount of credit default swaps (CDS) grew almost 48% in the first 6 months of 2005 alone, from $8.42 trillion to $12.43 trillion. The annual growth rate for credit derivatives was 128%, relative to $5.44 trillion in mid-2004.¹⁰

However, unlike equity markets with the high profile stock exchanges at their disposal this expanding market had nothing comparable, due to the fact that the market itself was over-the-counter (OTC). The ABX.HE indexes provided standardized indices for the credit market promoting liquidity, credibility and visibility, while also enabling market participants to track CDS spreads. They are produced by the Markit Group and began trading on 19 January 2006.

The name ABX.HE denotes “Asset-Backed Securities Index-Home Equity” and each index represents a standardized basket of home equity asset-backed reference obligations, basically a basket of synthetic collateralized debt obligations (CDOs) underlying subprime mortgages. Each index is a series of equally weighted, static portfolios of CDS and so in reality trades based on the ABX are trades of CDSs.

The ABX trades on the basis of the index value. The indexes have been used as a key measurement of subprime mortgage market conditions as well as to value CDOs. However, considering that there are actually approximately 15 tranches in each mortgage-backed security and the ABX only take into account five of these (AAA, AA, A, BBB, BBB-) they cannot be seen as perfect representatives of the market. Nonetheless they are the closest proxy available (Finger 2007).

There were only four ABX.HE Indices issued, with the first vintage issued at the beginning of 2006 offering the longest time period. The ABX.HE 2008/1 vintage was postponed due to lack of appropriate collateral time and time again and it looks unlikely that there will be a new issuance.

Each index is based on 20 subprime mortgage backed securities, with the same credit rating, issued over the previous 6-month period and indices are renewed or “rolled” every 6 months. In order to be included in the index each RMBS must meet stringent requirements, such as the deal size must be at least $500 million, the weighted average FICO score of the creditors backing the securities issued in the RMBS transaction may not be greater than 660 and at least four of the required tranches must be registered according to the U.S. Securities Act of 1933.¹¹ Markit ABX Index Rules, see http://content.markitcdn.com/corporate/Company/Files/DownloadFiles?CMSID=b7a69adc399f48fb83f32fedec1b8703.

Fender and Scheicher (2009), propose one way to calculate ABX prices as:

$$ Price=100+ Present value of coupons- Present value of writedowns $$

(5)

One hundred is the par value of the index. The coupon rate is fixed as a percentage of notional over the life of the index on initiation of a new vintage. It is paid by the protection buyer to the protection seller for insurance against a credit event occurring. The present value of write-downs or losses is variable and is paid from the protection seller to the buyer in the case of a credit event. We can now see that it is vital that the value of the coupons is high enough to cover potential losses. However, as the crisis hit, these were not and when defaults began accumulating write-downs rapidly increased. Protection sellers simply could not afford to cover the losses (Brunnermeier 2009).