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Stochastic control of credit default insurance for subprime residential mortgage‐backed securities
Optimal Control Applications and Methods
Abstract
Subprime residential mortgage securitization and its associated risks have been a major topic of discussion since the onset of the mortgage crisis in July 2007. In this paper, we provide a stochastic dynamic model for investing bank profit under mortgage securitization. In addition, aspects of this model are illustrated by means of a numerical example. In addition, we solve a stochastic optimal credit default insurance problem that has the cash outflow rate for satisfying depositor obligations, the investment in structured mortgage products and credit default insurance as controls. As far as the latter is concerned, we compute credit default swap and accrued premiums by considering the credit rating of structured mortgage products such as residential mortgage‐backed securities and collateralized debt obligations. Copyright © 2011 John Wiley & Sons, Ltd.
... Especially, the irrational behavior of micro-economic entities and the inappropriate financial policy of the government will exacerbate the negative effects of asset securitization. The obvious example is the excessive creation of financial assets and the over-financing and thus the subprime credit expansion as a consequence, which is also the basic reasons that led to the subprime mortgage crisis in the U.S. [7]. This paper will focus on such deep-seated problems including the asset securitization, the financial asset creation, the over-financing, the subprime credit expansion, the subprime crisis and so forth, to systematically investigate the underlying causes and mechanisms of the subprime mortgage crisis in the U.S. and thus global financial crisis triggered by it. ...
... In the case of interest rate rise, the expected housing prices will inevitably decline. When the housing prices stopped rising or took a decline, the subprime risks were fully exposed, thus leading to the subprime crisis [7]. ...
This paper investigates some of the risk and insurance issues related to the subprime mortgage crisis. The discussion takes place in a discrete-time framework with a subprime investing bank
being considered to be regret and risk averse before and during the mortgage crisis, respectively.
In particular, we investigate the bank's investment choices related to risky subprime structured
mortgage products and riskless treasuries. We conclude that if the bank takes regret into account,
it will be exposed to higher risk when the difference between the expected returns on subprime
structured mortgage products and treasuries is small. However, there is low-risk exposure when this
difference is high. Furthermore, we assess how regret can influence the bank's view of a rate of return
guarantee from monoline insurers. We find that before the crisis, regret decreased the investment
bank's preparedness to forfeit on returns when its structured product portfolio was considered to
be safe. Alternatively, risk- and regret-averse banks forfeit the same returns when their structured
mortgage product portfolio is considered to be risky. We illustrate the aforementioned findings
about structured mortgage products and monoline insurance via appropriate examples.
This contribution is the second in a series of papers on discrete-time modeling of bank capital
regulation and its connection with the subprime mortgage crisis (SMC). The latter was caused
by, amongst other things, the downturn in the U.S. housing market, risky lending and borrowing
practices, inaccurate credit ratings, credit default swap contracts as well as excessive individual
and corporate debt levels. The Basel II Capital Accord's primary tenet is that banks should
be given more freedom to decide how much risk exposure to permit; a practice brought into
question by the SMC. For instance, institutions worldwide have badly misjudged the risk related
to investments ranging from subprime mortgage loans to mortgage-backed securities (MBSs).
Also, analysts are now questioning whether Basel II has failed by allowing these institutions
to provision less capital for subprime mortgage loan losses from highly rated debt, including
MBSs. Other unintended consequences of Basel II include the procyclicality of credit ratings
and changes in bank lending behavior. Our main objective is to model the dependence of bank
credit and capital on the level of macroeconomic activity under Basel I and Basel II as well as
its connection with banking behavior for the period before and during the SMC.
The ongoing subprime mortgage crisis (SMC) and implementation of Basel II Capital Accord regulation have resulted in issues related to bank valuation and profitability becoming more topical. Profit is a major indicator of financial crises for households, companies, and financial institutions. An SMC-related example of this is the U.S. bank, Wachovia Corp., which reported major losses in the first quarter of 2007 and eventually was bought by Citigroup in September 2008. A first objective of this paper is to value a bank subject to Basel II based on premiums for market, credit, and operational risk. In this case, we investigate the discrete-time dynamics of banking assets, capital, and profit when loan losses and macroeconomic conditions are explicitly considered. These models enable us to formulate an optimal bank valuation problem subject to cash flow, loan demand, financing, and balance sheet constraints. The main achievement of this paper is bank value maximization via optimal choices of loan rate and supply which leads to maximal deposits, provisions for deposit withdrawals, and bank profitability. The aforementioned loan rates and capital provide connections with the SMC. Finally, OECD data confirms that loan loss provisioning and profitability are strongly correlated with the business cycle.
We address the impact of speculative mortgage funding on the pricing of subprime residential mortgage loans (measured by risk premia) and securities backed by these mortgages (measured by ABX.HE indices). In this regard, we make use of techniques involving multivariate Vector Autoregressive (VAR) models and Generalized Impulse Response Functions (GIRFs) in order to study the shocks related to this type of funding. More specifically, the VAR model utilized in this article estimates individual regressions within a system where all mortgage variables are endogenously determined. Furthermore, the aforementioned response functions provide a means of determining the impact of shocks within a given horizon. Our main conclusions are that mortgage price is most significantly affected by shocks from mortgage rates, while, for ABX price, shocks to speculative mortgage funding, ABX price, mortgagor risk characteristics and prepayment rate elicit significant responses. In addition, our findings indicate that speculative mortgage funding has driven up mortgage and ABX price and contributes to increased volatility in related markets.
In this paper, we test the influence of various fundamental variables on the pricing of credit default swaps. The theoretical determinants that are important for pricing credit default swaps include the risk-free rate, industry sector, credit rating, and liquidity factors. We suggest a linear regression model containing these different variables, especially focusing on liquidity factors. Unlike bond spreads which have been shown to be inversely related to liquidity (i.e., the greater the liquidity, the lower the spread), there is no a priori reason that the credit default swap spread should exhibit the same relationship. This is due to the economic characteristics of a credit default swap compared to a bond. Our empirical result shows that all the fundamental variables investigated have a significant effect on the credit default swap spread. Moreover, our findings suggest that credit default swaps that trade with greater liquidity have a wider credit default swap spread.
We provide sufficient conditions for a dynamic consumption–portfolio problem in continuous time to have a solution. When the price processes satisfy a regularity condition, all utility functions that are continuous, increasing, concave, and are dominated by a strictly concave power function admit a solution.
A company’s credit default swap spread is the cost per annum for protection against a default by the company. In this paper we analyze data on credit default swap spreads collected by a credit derivatives broker. We first examine the relationship between credit default spreads and bond yields and reach conclusions on the benchmark risk-free rate used by participants in the credit derivatives market. We then carry out a series of tests to explore the extent to which credit rating announcements by Moody’s are anticipated by participants in the credit default swap market.
A topical issue in financial economics is the development of a stochastic dynamic model for bank behaviour. Under the assumption that the loan market is imperfectly competitive, we investigate the evolution of banking items such as loans, provisions for loan losses and deposit withdrawals, Treasuries and deposits and their relationship with profit. A motivation for studying this type of problem is the need to generalize the more traditional discrete-time models that are being used in the majority of studies that analyse banks and their operational idiosyncracies. An important outcome of our research is an explicit model for bank profit based solely on the stochastic dynamics of bank assets (loans, Treasuries and reserves) and liabilities (deposits). By way of conclusion, we provide a brief discussion of some of the economic aspects of the dynamic bank modelling undertaken in the main body of the article.
In this brief research article, we consider the financial modelling of the process of mortgage loan securitization that has been a root cause of the ongoing Subprime Mortgage Crisis (SMC). In particular, we suggest a Levy process-driven model of bank leverage profit that arises from the securitization of a pool of subprime mortgage loans. To achieve this, we develop stochastic models for mortgage loans, mortgage loan losses, credit ratings and mortgage loan guarantees in a subprime context. These models incorporate some of the most important issues related to the SMC and its causes. Finally, we provide a brief analysis of the models developed earlier in our contribution and its relationship with the SMC.
Using loan-level data, we analyze the quality of subprime mortgage loans by adjusting their performance for differences in borrower characteristics, loan characteristics, and macroeconomic conditions. We find that the quality of loans deteriorated for six consecutive years before the crisis and that securitizers were, to some extent, aware of it. We provide evidence that the rise and fall of the subprime mortgage market follows a classic lending boom-bust scenario, in which unsustainable growth leads to the collapse of the market. Problems could have been detected long before the crisis, but they were masked by high house price appreciation between 2003 and 2005. © The Author 2011. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved.
The distance between small firms and their lenders is increasing, and they are communicating in more impersonal ways. After documenting these systematic changes, we demonstrate they do not arise from small firms locating differently, consolidation in the banking industry, or biases in the sample. Instead, improvements in lender productivity appear to explain our findings. We also find distant firms no longer have to be the highest quality credits, indicating they have greater access to credit. The evidence indicates there has been substantial development of the financial sector, even in areas such as small business lending. SMALL BUSINESS LENDING HAS HISTORICALLY been very costly, because of the pau
The distance between small firms and their lenders is increasing, and they are communicating in more impersonal ways. After documenting these systematic changes, we demonstrate they do not arise from small firms locating differently, consolidation in the banking industry, or biases in the sample. Instead, improvements in lender productivity appear to explain our findings. We also find distant firms no longer have to be the highest quality credits, indicating they have greater access to credit. The evidence indicates there has been substantial development of the financial sector, even in areas such as small business lending. Copyright The American Finance Association 2002.
The subprime panic. Yale ICF Working Paper No. 08-25 Available from SSRN
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