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The Bear's Lair: Index Credit Default Swaps and the Subprime Mortgage Crisis

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  • Richard Stanton
  • Nancy Wallace
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    Abstract

    During the recent financial crisis, ABX.HE index credit default swaps (CDS) on baskets of mortgage-backed securities were a benchmark widely used by financial institutions to mark their subprime mortgage portfolios to market. However, we find that prices for the AAA ABX.HE index CDS during the crisis were inconsistent with any reasonable assumption for mortgage default rates, and that these price changes are only weakly correlated with observed changes in the credit performance of the underlying loans in the index, casting serious doubt on the suitability of these CDS as valuation benchmarks. We also find that the AAA ABX.HE index CDS price changes are related to short-sale activity for publicly traded investment banks with significant mortgage market exposure. This suggests that capital constraints, limiting the supply of mortgage-bond insurance, may be playing a role here similar to that identified by Froot (2001) in the market for catastrophe insurance. The Author 2011. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oup.com., Oxford University Press.

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    File URL: http://hdl.handle.net/10.1093/rfs/hhr073
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    Bibliographic Info

    Article provided by Society for Financial Studies in its journal Review of Financial Studies.

    Volume (Year): 24 (2011)
    Issue (Month): 10 ()
    Pages: 3250-3280

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    Handle: RePEc:oup:rfinst:v:24:y:2011:i:10:p:3250-3280

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    Cited by:
    1. Wojtowicz, Marcin, 2014. "CDOs and the financial crisis: Credit ratings and fair premia," Journal of Banking & Finance, Elsevier, vol. 39(C), pages 1-13.
    2. Driessen, Joost & Van Hemert, Otto, 2012. "Pricing of commercial real estate securities during the 2007–2009 financial crisis," Journal of Financial Economics, Elsevier, vol. 105(1), pages 37-61.
    3. Warren Bailey & Lin Zheng & Yinggang Zhou, 2012. "What Makes the VIX Tick?," Working Papers 222012, Hong Kong Institute for Monetary Research.

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