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The pricing of subprime mortgage risk in good times and bad: evidence from the ABX.HE indices

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  • Ingo Fender
  • Martin Scheicher

Abstract

This paper investigates the market pricing of subprime mortgage risk on the basis of data for the ABX.HE family of indices, which have become a key barometer of mortgage market conditions during the recent financial crisis. After an introduction into ABX index mechanics and a discussion of historical pricing patterns, we use regression analysis to establish the relationship between observed index returns and macroeconomic news as well as market-based proxies of default risk, interest rates, liquidity and risk appetite. The results imply that declining risk appetite and heightened concerns about market illiquidity - likely due in part to significant short positioning activity - have provided a sizeable contribution to the observed collapse in ABX prices since the summer of 2007. In particular, while fundamental factors, such as indicators of housing market activity, have continued to exert an important influence on the subordinated ABX indices, those backed by AA and AAA exposures have tended to react more to the general deterioration of the financial market environment. This provides further support for the inappropriateness of pricing models that do not sufficiently account for factors such as risk appetite and liquidity risk, particularly in periods of heightened market pressure. In addition, as related risk premia can be captured by unconstrained investors, ABX pricing patterns appear to lend support to government measures aimed at taking troubled assets off banks' balance sheets - such as the US Troubled Asset Relief Program (TARP).

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Bibliographic Info

Paper provided by Bank for International Settlements in its series BIS Working Papers with number 279.

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Length: 40 pages
Date of creation: Mar 2009
Date of revision:
Handle: RePEc:bis:biswps:279

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Keywords: ABX index; mortgage-backed securities; pricing; risk premia;

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References

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  1. Paul S. Mills & John Kiff, 2007. "Money for Nothing and Checks for Free," IMF Working Papers, International Monetary Fund 07/188, International Monetary Fund.
  2. Pierre Collin-Dufresne, 2001. "The Determinants of Credit Spread Changes," Journal of Finance, American Finance Association, American Finance Association, vol. 56(6), pages 2177-2207, December.
  3. Benjamin Yibin Zhang & Hao Zhou & Haibin Zhu, 2005. "Explaining credit default swap spreads with the equity volatility and jump risks of individual firms," Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System (U.S.) 2005-63, Board of Governors of the Federal Reserve System (U.S.).
  4. Coudert, Virginie & Gex, Mathieu, 2008. "Does risk aversion drive financial crises? Testing the predictive power of empirical indicators," Journal of Empirical Finance, Elsevier, Elsevier, vol. 15(2), pages 167-184, March.
  5. John Y. Campbell & Glen B. Taksler, 2003. "Equity Volatility and Corporate Bond Yields," Journal of Finance, American Finance Association, American Finance Association, vol. 58(6), pages 2321-2350, December.
  6. Francis A. Longstaff & Sanjay Mithal & Eric Neis, 2005. "Corporate Yield Spreads: Default Risk or Liquidity? New Evidence from the Credit Default Swap Market," Journal of Finance, American Finance Association, American Finance Association, vol. 60(5), pages 2213-2253, October.
  7. Jeffery D Amato & Eli M Remolona, 2003. "The credit spread puzzle," BIS Quarterly Review, Bank for International Settlements, Bank for International Settlements, December.
  8. Ingo Fender & John Kiff, 2004. "CDO rating methodology: Some thoughts on model risk and its implications," BIS Working Papers, Bank for International Settlements 163, Bank for International Settlements.
  9. Allen Frankel, 2006. "Prime or not so prime? An exploration of US housing finance in the new century," BIS Quarterly Review, Bank for International Settlements, Bank for International Settlements, March.
  10. Cantor, Richard, 2004. "An introduction to recent research on credit ratings," Journal of Banking & Finance, Elsevier, Elsevier, vol. 28(11), pages 2565-2573, November.
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Cited by:
  1. Dungey, Mardi & Dwyer, Gerald P. & Flavin, Thomas, 2011. "Systematic and Liquidity Risk in Subprime-Mortgage Backed Securities," Working Papers, University of Tasmania, School of Economics and Finance 11817, University of Tasmania, School of Economics and Finance.
  2. Gary B. Gorton & Andrew Metrick, 2009. "Securitized Banking and the Run on Repo," NBER Working Papers 15223, National Bureau of Economic Research, Inc.
  3. Ingo Fender & Bernd Hayo & Matthias Neuenkirch, 2011. "Daily CDS pricing in emerging markets before and during the global financial crisis," MAGKS Papers on Economics, Philipps-Universität Marburg, Faculty of Business Administration and Economics, Department of Economics (Volkswirtschaftliche Abteilung) 201139, Philipps-Universität Marburg, Faculty of Business Administration and Economics, Department of Economics (Volkswirtschaftliche Abteilung).
  4. Fender, Ingo & Hayo, Bernd & Neuenkirch, Matthias, 2012. "Daily pricing of emerging market sovereign CDS before and during the global financial crisis," Journal of Banking & Finance, Elsevier, Elsevier, vol. 36(10), pages 2786-2794.

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