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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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  • Fender, Ingo
  • Scheicher, Martin
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    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 macroeco-nomic 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) in its original form. JEL Classification: E43, G12, G13, G14

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    Bibliographic Info

    Paper provided by European Central Bank in its series Working Paper Series with number 1056.

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    Date of creation: May 2009
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    Handle: RePEc:ecb:ecbwps:20091056

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

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    1. 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 2005-63, Board of Governors of the Federal Reserve System (U.S.).
    2. Ingo Fender & Martin Scheicher, 2008. "The ABX: how do the markets price subprime mortgage risk?," BIS Quarterly Review, Bank for International Settlements, September.
    3. Haibin Zhu & Benjamin Yibin Zhang & Hao Zhou, 2005. "Explaining credit default swap spreads with equity volatility and jump risks of individual firms," BIS Working Papers 181, Bank for International Settlements.
    4. Hull, John & Predescu, Mirela & White, Alan, 2004. "The relationship between credit default swap spreads, bond yields, and credit rating announcements," Journal of Banking & Finance, Elsevier, vol. 28(11), pages 2789-2811, November.
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    11. Adam B. Ashcraft & Til Schuermann, 2008. "Understanding the securitization of subprime mortgage credit," Staff Reports 318, Federal Reserve Bank of New York.
    12. Virginie Coudert & Mathieu Gex, 2007. "Does Risk Aversion Drive Financial Crises? Testing the Predictive Power of Empirical Indicators," Working Papers 2007-02, CEPII research center.
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    14. Bruce Mizrach, 2008. "Jump and Cojump Risk in Subprime Home Equity Derivatives," Departmental Working Papers 200802, Rutgers University, Department of Economics.
    15. Ingo Fender & John Kiff, 2004. "CDO rating methodology: Some thoughts on model risk and its implications," BIS Working Papers 163, Bank for International Settlements.
    16. Danis, Michelle A. & Pennington-Cross, Anthony, 2008. "The delinquency of subprime mortgages," Journal of Economics and Business, Elsevier, vol. 60(1-2), pages 67-90.
    17. Ying Huang & Salih Neftci & Ira Jersey, 2002. "What Drives Swap Spreads, Credit or Liquidity?," ICMA Centre Discussion Papers in Finance icma-dp2003-05, Henley Business School, Reading University.
    18. Paul S. Mills & John Kiff, 2007. "Money for Nothing and Checks for Free," IMF Working Papers 07/188, International Monetary Fund.
    19. Benjamin J. Keys & Tanmoy Mukherjee & Amit Seru & Vikrant Vig, 2010. "Did Securitization Lead to Lax Screening? Evidence from Subprime Loans," The Quarterly Journal of Economics, MIT Press, vol. 125(1), pages 307-362, February.
    20. Joshua D. Coval & Jakub W. Jurek & Erik Stafford, 2009. "Economic Catastrophe Bonds," American Economic Review, American Economic Association, vol. 99(3), pages 628-66, June.
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