The high default rates and massive downgrades of seemingly high quality (e.g., AAA-rated) Mortgage backed Securities in 2007 and 2008 hit financial markets and investors by surprise during the Global Financial Crisis (GFC). Models applied by credit rating agencies (CRA) along with misaligned incentives based on ‘paid-by-originator’- business models have been blamed as major sources of the crisis (compare Hellwig 2008, Hull 2009, Crouhy et al. 2008).
In particular, market participants who applied interpretation standards to securitization ratings which are similar to corporate bond issue and issuer ratings (which evolved over many years, see e.g., Ederington & Goh 1993) were surprised to see an unprecedented increase in default rates. Figure 1 compares the impairment rates for Baa-rated bonds with Baa-rated mortgage-backed securities (MBS) which are collateralised by prime mortgages and Baa-rated home equity loan (HEL) securities which are mostly collateralized by sub-prime mortgages. Both MBS and HEL are securitizations of real-estate linked loan portfolios. Default rates for Baa-rated bonds fluctuate from 1997 to 2008 between zero and 1.2%, while default rates for Baa-rated MBS fluctuate between zero and 29.2% and default rates for Baa-rated HEL fluctuate between 0.2% and 46.0%.
This paper proves that the risk characteristics between securitizations and corporate bonds differ significantly particularly with respect to the exposure to systematic risk. Securitizations are portfolio related instruments which contain a higher degree of systematic risk because of diversification of idiosyncratic risks.
In addition, parameter instability and uncertainty is important, as time series information is limited in this area due to the recent origination, see Tarashev & Zhu (2008) for common credit portfolios. This view is supported for securitizations by Coval et al. (2009) who show that variations of the pool default correlation can have a substantial impact on the risk of the tranches and Heitfield (2009) who provides a simulation study which shows the impact of estimation errors in pool correlations on the risk measures and ratings of tranches. Next to the analytical evidence, this paper complements these contributions by providing an empirical analysis with data for securitizations before and during the financial crisis.
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Systematic Risk and Parameter Uncertainty in Mortgage Securitizations
