Subprime Mortgage Defaults and Credit Default Swaps

• Date: 01 April 2015
• DOI: http://doi.org/10.1111/jofi.12221
• Published date: 01 April 2015

THE JOURNAL OF FINANCE •VOL. LXX, NO. 2 •APRIL 2015

Subprime Mortgage Defaults and Credit Default

Swaps

ERIC ARENTSEN, DAVID C. MAUER, BRIAN ROSENLUND, HAROLD H. ZHANG,

and FENG ZHAO∗

ABSTRACT

We offer the first empirical evidence on the adverse effect of credit default swap

(CDS) coverage on subprime mortgage defaults. Using a large database of privately

securitized mortgages, we find that higher defaults concentrate in mortgage pools

with concurrent CDS coverage, and within these pools the loans originated after or

shortly before the start of CDS coverage have an even higher delinquency rate. The

results are robust across zip code and origination quarter cohorts. Overall, we show

that CDS coverage helped drive higher mortgage defaults during the financial crisis.

THE SHARP INCREASE IN DEFAULTS on residential mortgage loans was a driv-

ing force behind the 2007 to 2008 financial crisis.1Several recent studies

attribute the surge in defaults to looser lending standards associated with the

“originate-to-distribute” mortgage loan model—under this model, loans are

quickly sold to securitizers, which may reduce lenders’ incentive to carefully

screen and monitor borrowers (see, e.g., Mian and Sufi (2009), Keys et al.

(2010), and Purnanandam (2011)).2In this paper, we contribute to the growing

∗Arentsen and Rosenlund are at TCW Group Inc.; Mauer is at the Tippie School of Business,

University of Iowa; Zhang and Zhao are at the Jindal School of Management, University of Texas

at Dallas. For valued input we thank an anonymous referee, Cliff Ball, Nick Bollen, Cam Harvey

(Editor), Victoria Ivashina (AFAdiscussant), Robert Jarrow, Hayne Leland, Stan Liebowitz, David

Parsley, Sorin Sorescu, Stuart Turnbull, Xiao Wang, Yilei Zhang, and seminar participants at the

2013 American Finance Association Meeting, the 23rd Annual Derivatives and Risk Management

Conference, University of Hong Kong, University of Iowa, University of North Dakota, Shanghai

Advanced Institute of Finance (SAIF), Singapore Management University,Texas A&M University,

Tsinghua University, and Vanderbilt University. We are also grateful to Jason Friend at LPS

Applied Analytics for data assistance. TCW has cooperated in this paper as part of its desire to

encourage and support academic research in finance. The views expressed in the paper do not

represent opinions of TCW. All remaining errors are our own.

1The increase in mortgage defaults was particularly significant for subprime mortgages, which

are loans made to borrowers with poor credit histories and/or high levels of personal debt. For

example, Mayer, Pence, and Sherlund (2009) report that the proportion of subprime mortgages in

default increased from 5.6% in mid-2005 to over 21% in mid-2008.

2Under the originate-to-distribute model, the lender sells loans to a financial institution that

packages them into mortgage-backed securities, which are then sold to investors—a process re-

ferred to as securitization. Parlour and Plantin (2008) show theoretically that the process by

which banks sell loans to securitizers may reduce banks’ incentive to monitor. Others argue that

inaccurate credit ratings on subprime mortgage-backed securities—driven in part by the

DOI: 10.1111/jofi.12221

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690 The Journal of Finance R

literature on the 2007 to 2008 financial crisis by providing the first evidence

of a link between credit default swaps (CDS) and subprime mortgage defaults.

We argue that the subprime mortgage supply chain, from the originator

selling the loans to the securitizer pooling them and selling mortgage-backed

securities (MBS) to investors, was influenced significantly by the credit

derivatives market. In particular, CDS on subprime MBS allowed securitizers

and investors to hedge the credit risk of the underlying loans.3Since MBS

market participants could limit their exposure to securitizations of risky loans,

they were less concerned about the decline in credit quality of loans being

pushed out by originators. The decrease in sensitivity to loan quality together

with the increase in demand for highly rated MBS by investors chasing high

yields drove a reduction in lending standards by mortgage loan originators

who earned lucrative fees to supply the loans.4

According to this argument, CDS contracts referencing subprime MBS deals

were positively related to the default rate of loans underlying the MBS. To

test this prediction, we use a large sample of subprime mortgage loans orig-

inated during the 2003 to 2007 period and privately securitized by commer-

cial banks (e.g., Bank of America), investment banks (e.g., Bear Sterns), and

finance companies that specialized in loan origination (e.g., New Century Fi-

nancial Corporation). Our sample comes from a database constructed by First

American CoreLogic Loan Performance. This database contains more than 90%

of the subprime loans that were privately securitized during this 2003 to 2007

period. In addition to loan origination date and information on the mortgage

loan pool, the securitizer, and the MBS where the loan is placed, the database

provides detailed information on borrower and loan characteristics. We supple-

ment this information with data from various sources on regional housing and

economic conditions at the time of loan origination.

Next, we identify which loans in the LoanPerformance database were covered

by CDS contracts. Since privately securitized loans were placed in mortgage

pools that were used to construct MBS deals, we work backwards by first identi-

fying whether an MBS is referenced by a CDS contract and then identifying the

issuer-pays model of credit ratings—contributed to the 2007 to 2008 financial crisis (see, e.g.,

Opp, Opp, and Harris (2013)).

3CDS are insurance contracts where the buyer pays a premium to the seller, who in the event

of default must compensate the buyer for the difference between the notional principal insured

and the amount recovered. Purchasers of CDS on MBS are compensated in the event of defaults

on loans in mortgage pools underlying the MBS tranches. Note that the purchaser of protection

(the entity with the long position) and the seller of protection (the entity with the short position)

may not own the underlying asset referenced in the CDS contract. Thus, the sum of the notional

principal on any single referenced asset (e.g., an MBS tranche or a corporate bond) can be many

times the principal of the asset.

4During this time period there was a huge increase in the size of the market for CDS. According

to statistics reported by the International Swaps and Derivatives Association, CDS notional prin-

cipal increased almost 100 times from $631.5 billion in the first half of 2001 to $62,173.20 billion

in the second half of 2007, before starting to decline in 2008. Stulz (2010) examines the dramatic

growth and decline in the overall CDS market from its inception in the mid-1990s through the end

of 2008.

Subprime Mortgage Defaults and Credit Default Swaps 691

mortgage pools underlying the MBS and the individual subprime loans in the

mortgage pools. In particular, we use synthetic collateralized debt obligations

(CDOs) compiled by Intex Solutions to identify CDS contracts on MBS,5and

use the unique deal number in the LoanPerformance database to determine

whether a loan is in a mortgage pool used to construct an MBS with tranches

referenced by a CDS contract.

We find that more than 35% of the subprime loans in the sample are in a

mortgage pool with CDS coverage in close proximity to the closing date of the

MBS that contains the pool. We use this variation across mortgage pools to test

whether CDS protection encouraged the origination of risky subprime loans

with a higher default rate compared to subprime loans without CDS protection

or subprime loans covered by CDS contracts well after the MBS closing date.

Using a probit model that controls for a wide variety of factors predicted

to influence mortgage default, we find that CDS coverage has a significantly

positive effect on subprime loan delinquency. Specifically, for loans in pools

where the CDO settlement date is no later than 180 days after the MBS closing

date, we find that CDS coverage increases the probability of loan delinquency

by 3.3% over the full sample period (2003 to 2007) and 5.4% over the 2004 to

2006 subperiod when CDS coverage of subprime loans reached its highest level.

The effect of CDS coverage becomes more significant when we use a narrower

window and require that the CDO settlement date be before the MBS closing

date. For example, if the CDO settlement date is within the 90 days prior to the

MBS closing date, the increase in the probability of loan delinquency is 6.7%

and 5.9% over the 2003 to 2007 and 2004 to 2006 periods, respectively.

To mitigate the concern that our results are due to CDS contracts being

used to hedge the risk of already-outstanding loans, rather than CDS contracts

encouraging the origination of riskier loans, we use propensity score matching

(PSM). Specifically, we compare the delinquency rates in our sample of loans

with CDS coverage to a matching sample of loans without CDS coverage. The

matching is based on a propensity score model that uses borrower and loan

characteristics to predict the likelihood that a loan will have CDS coverage. We

continue to find a significant effect of CDS coverage on the loan delinquency

rate.

Another potential concern is that our results could be explained by geogra-

phy or time period if loans with CDS coverage concentrate in regions of the

country and/or time periods with high mortgage defaults. We control for this

possibility by constructing zip code and origination quarter loan cohorts and

grouping the cohorts by percentage of loans with CDS coverage. We continue

5Synthetic CDOs are portfolios of CDS contracts on underlying assets that may include MBS,

corporate bonds, or other fixed income securities. Synthetic CDOs are typically divided into credit

tranches based on the level of credit risk assumed. Investors can buy components of synthetic

CDOs. All tranches receive periodic payments based on the cash flows from the CDS. If a credit

event occurs in the underlying portfolio of assets (e.g., MBS), the synthetic CDO investors are

responsible for the losses, starting from the lowest-rated tranches up through the highest-rated

tranches.