To ensure a continuous supply of credit to home buyers, government sponsored agencies such as Fannie Mae, Freddie Mac and Ginnie Mae were chartered to purchase mortgages originated by local banks, provided they satisfy certain size and credit quality requirements.
Mortgages conforming to these requirements are repackaged by these agencies into mortgagebacked securities, and resold in capital markets with the implicit guarantee of the U.S. government. In contrast, mortgages that do not conform to size restrictions or borrower credit
quality standards, are not eligible for purchase by the government-sponsored enterprises and are either held by their issuers or sold directly in secondary markets. In recent years, issuance of so called “non-conforming” mortgages has increased significantly. For example, origination of subprime mortgages – mortgages given to those below the credit standards for the governmentsponsored enterprises grew from $96.8 billion in 1996 to approximately $600 billion in 2006, accounting for 22 percent of all mortgages issued that year (U.S. Securities and Exchange Commission, 2008). During the same period, the average credit quality of subprime borrowers decreased along a number of measures, as evidenced by rising ratios of mortgage values relative to house prices, an increased incidence of second lien loans, and issuance of mortgages with low or no documentation (Ashcraft and Schuermann, 2008). When house prices declined, the stage was set for a significant increase in default rates as many of these borrowers found themselves holding mortgages in excess of the market value of their homes.

Because subprime mortgages were ineligible for securitization by government sponsored agencies, they found their way into capital markets by way of “private-label” mortgage-backed securities, originated among others by Wall Street banks (FDIC Outlook, 2006). These securities carried the dual risk of high rates of default due to the low credit quality of the borrowers; and high levels of default correlation as a result of pooling mortgages from similar geographic areas and vintages. In turn, many subprime mortgage-backed bonds were themselves re-securitized into what are called collateralized mortgage obligations, effectively creating a CDO2. According to Moody’s, the share of collateralized debt obligations that had other “structured” assets as their collateral expanded from 2.6 percent in 1998 to 55 percent in 2006 as a fraction of the total notional of all securitizations. In 2006 alone, issuance of structured finance collateralized debt obligations reached $350 billion in notional value (Hu, 2007). As it turned out, all of the factors determining expected losses on tranches of collateralized debt obligations backed by mortgage-backed securities had been biased against the investor. First, the overlap in geographic locations and vintages within mortgage pools raised the prospect of higher-than-expected default correlations. Second, the probability of default and the expected recovery values have both been worse than expected due to the deterioration in credit quality of subprime borrowers and because of assets being sold off under financial pressure in “fire sales,” further driving down the prices of related assets.
Finally, the prevalence of CDO2 structures further magnified the deleterious effects of errors in estimates of expected losses on the underlying mortgages for investors. A succinct view of the severity of the deterioration in private-label residential mortgagebacked securities is provided by the ABX.HE indices. These indices are compiled by Markit in cooperation with major Wall Street banks, and track the performance of subprime residential mortgage backed securities along various points in the rating spectrum.8 For example, the ABX.HE.BBB 07-01 captures the average value of 20 BBB-rated mortgage backed securities obtained by pooling and tranching subprime mortgages issued in the first half of 2007. Intuitively, each of the underlying mortgage backed securities can be thought as loosely corresponding to a mezzanine CDO tranche in our simulation. Although the ABX.HE.BBB 07-01 index traded as high as 98.35, by August 2008, it had an average rating of CCC and a market price of roughly 5 cents on the dollar. With such abysmal performance in the residential mortgage backed market, CDOs backed by this type of structured collateral are virtually guaranteed to fail. As illustrated by our simulation, a CDO of investment grade mezzanine tranches, i.e. a CDO2, can sustain very large losses even with small changes in the realized default probabilities and correlations.

Incoming search terms for the article:

• abx house prices correlation
• market value of structured finance
• size structured finance market
• structured defaults fannie mae
• structured mortgage backed securities
• subprime issuance without conforming tranches
• subprime share of issuances