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Credit Derivatives and the Housing Market
Credit Derivatives and the Housing Market C King and A Pavlov, Simon Fraser University, Vancouver, BC, Canada ª 2012 Elsevier Ltd. All rights reserved.
Glossary Alt-A mortgage borrowers This class of mortgage borrowers includes new immigrants without a credit rating or self-employed individuals who cannot verify either employment or income; specific mortgage products exist for this borrower class. Collateral mortgage obligation This is a special purpose investment vehicle that as a legal entity owns mortgage assets within a pool. The mortgage assets represent the collateral and the mortgage pool provides cash flows for a bond issue sold to investors whereby specified tranches, for example senior, mezzanine, or equity, receive the distribution of cash flows subject to a contract which is referred to as the structure. Credit default swap This swap contract is an unfunded credit derivative that results in a buyer of the credit default swap making a series of payments to the seller of the credit default swap to obtain insurance-like protection in the event of a credit default. However, credit default swaps are not insurance since the buyer of the credit default swap does not need to own the underlying asset and the seller may not be a regulated entity and is not mandated to set aside a reserve fund from the premium payments to pay claims in the event of a credit default. Credit derivative This form of derivative is a bilateral contract and is negotiated over the counter, and not on an exchange, and is similar to other derivatives in that the seller of protection in a credit derivative contract receives premiums from the buyer of the protection until maturity, or until default, against the credit risk of the reference entity such as a mortgage pool. A credit derivative can be unfunded like a credit default swap or funded like collateralised debt obligations. Credit enhancement The purpose is to enhance the credit rating of an investment often fundamental to the securitisation transaction in structured finance. Similarly, it can reduce credit risk and provide, for
Housing Finance: Primary and Secondary Markets Homeownership is acknowledged globally to be a key factor in political and economic stability, according to the International Monetary Fund (IMF). Due to high land and construction costs relative to wages, homeownership requires a stable housing finance and mortgage system to succeed.
ECONOMICS/FINANCE
example, a lender or investor, with a guarantee of compensation if a borrower defaults by way of collateral, insurance, and/or some form of counterparty agreement. Credit risk Credit risk in housing finance means the risk that the mortgage borrower will default on a mortgage loan and the mortgage lender is not able to cover its loss due to foreclosure. Mortgage-backed security Referred to as MBS, this asset-backed security represents a claim on the principal and interest cash flows from a pool of mortgage loans originated from various financial institutions. MBS is typically sold as bonds and because mortgage borrowers can prepay mortgages there is the potential for prepayment risk. Credit risk also exists unless the mortgage assets are insured or guaranteed. Mortgage loan insurance On high loan-to-value mortgages, typically where the mortgage borrower does not have a 20% downpayment, there is often a legislative mandate to require mortgage loan insurance to be obtained from a mortgage loan insurance supplier. Mortgage loan insurance is also integral to MBS. The premium is paid to the insurance company at the time of mortgage funding to insure or guarantee the mortgage lender against loss due to foreclosure. Subprime mortgage lending The common misperception is that subprime mortgage borrowers can be defined by a type of mortgage product such as mortgages with zero downpayments, extended amortisations, or interest-only payments. Subprime mortgage borrowers are properly defined by their respective credit rating. A subprime mortgage borrower is someone that obtains a mortgage loan even though they have an impaired credit rating, usually due to a recent bankruptcy or when payments on personal debt obligations including taxes have been missed and are in arrears.
This reality seems to hold in any jurisdiction as reported by the IMF, and most new homebuyers seek out mortgages with terms of 15, 25, or more years and mortgages are often refinanced to pay for home maintenance, renovations, or other household consumption. The length of the mortgage amortisation period exposes borrowers to high interest costs and the potential for credit default is not insignificant as macroeconomic and personal fortunes can change.
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Table 1 Mortgage funding sources Retail
Wholesale
Primary funding Individual Bank Accounts Raised from companies and capital markets Current accounts Short call deposits Certificates of deposit Commercial paper Bonds Secondary funding Residential mortgage-backed securities Mortgage-backed bonds and structured covered bonds
In most mortgage systems, government-regulated len ders are responsible for origination, servicing, funding, and portfolio management of mortgage loans. The sources of funds for the mortgage loans are debt obligations of the lender. These obligations are in most cases deposits but may also be in the form of mortgage (or nonmortgage) bonds, dedicated savings, and loans from other financial institutions or from special liquidity (warehouse) facil ities, as outlined in Table 1. Basel I and II set forth minimum regulatory capital requirements that financial institutions must adhere to as part of credit risk management. The mandated minimum capital requirement in most nations therefore mortgage lending that is carried on the balance • limits sheet of a financial institution; whether financial institutions buy mortgage • influences loan insurance as this reduces or eliminates the capital
•
requirement for mortgages carried on the balance sheet; and results in a flow-through of mortgage loans into the secondary market, thus removing mortgage loans from the balance sheet.
Some mortgage lenders, which are referred to as monoline lenders, focus only on mortgage lending. They do not have funding available from retail sources and thus wholesale funding sources and securitisation are the only options to secure mortgage credit. Consolidating loans or other debt instruments into single assets or securities is called securitisation. The secondary mortgage market has evolved mortgage finance to a more specialised activity and the originator of the loan often does not hold it until maturity. Residential mortgage-backed securities (MBS or RMBS), collateral debt obligations (CDOs), and asset-backed commercial paper (ABCP) are bought and sold in financial markets much like stocks. These assets are transferred from the balance sheet of the mortgage originator to a company that is legally separate, called a special purpose vehicle (SPV). With an MBS, the originating firm retains any excess interest over the all-in cost of the securitisation but removes the loans and any associated capital require ment from its balance sheet. It is the SPV that acquires legal title to the mortgages and issues the MBS where it is managed with payments then made to investors based on the performance of the specific pool of mortgages. Figure 1 provides a graphic of a basic MBS. The cash flow from the mortgage pool is redistributed to the dif ferent tranches (known as ‘tranche’ from the French word for ‘slice’) based on a set of sequential payment rules, with Mortgage-backed securities are broken up into groups with investor cash flows derived from the original mortgage pool
Mortgage loan Senior secured
Mortgage loan
Last loss
Mortgage loan
Lowest risk
Mortgage loan Mortgage loan Mortgage loan
Special purpose vehicle:
Mortgage loan Mortgage loan Mortgage loan Mortgage loan
Pool of mortgage loans
Sale to investors at different levels of risk
Lowest Return Mezzanine Incur loss after Equity, but medium Risk and return Equity
Mortgage loan
Unsecured
Mortgage loan
First loss
Mortgage loan
High risk and return
Figure 1 Mortgage-backed securities. Collaterised mortgage obligations divide mortgage pool into tranches.
Credit Derivatives and the Housing Market
interest and principal paid starting with the senior secured. Prepayment of mortgage loans can alter cash flow into each tranche. Some MBSs use an accrual tranche when one or more tranches do not purposefully receive a payment in a particular period. Different variations of accrual tranches relate to changes in lending rates. Floating rate tranches are created from fixed rate tranches, with London Interbank Offered Rate (LIBOR) often used as the reference rate. Inverse floaters or stripped MBSs segregate the cash flows from the under lying security and provide investors with cash flow from either interest-only or principal-only components. There are modifiable and combinable features that provide investors with synthetic coupon options, an effective hedging tool. Planned amortisation class (PAC) bonds allow for the payment of a stream of principal amounts. Mortgage-backed bonds are secured debt securities issued by mortgage credit institutions supported by resi dential mortgages that remain on the balance sheet of the issuer. Individual mortgage-backed bonds can be substi tuted with other mortgage loans from the originator’s portfolio. There are some substitution limitations, such as the requirement for a match in terms of duration and quality of the mortgage asset.
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private suppliers of mortgage loan insurance. While it is a form of credit insurance, credit insurance is more often used to refer to policies that cover other kinds of debt. Insured mortgages serve mortgage systems by reducing or eliminating capital requirements, and MBS-insured mort gages provide an extra security to investors. The traditional view of lenders is that borrowers with out a credit history or lacking ability to manage debt are not suitable candidates for mortgages at any loan rate. The recent performance of US private mortgage loan insurance providers suggests that mortgage underwriting can be challenging in a weak housing market when bor rowers have little or negative home equity. Defaults for US insured mortgages among the largest mortgage insurers, with statistics tracked by the Mortgage Insurance Companies of America, ranged from between 210 000 and 350 000 per annum in the 1990s to more than 1 000 000 defaults in 2009. This is significant given that insured mortgages go through a dual underwriting pro cess whereby the originating lender underwrites the mortgage loan and then forwards this to a mortgage loan insurer that again underwrites the application (except in the case of delegated underwriting common in the United States) so as to validate the application and charge an appropriate insurance premium.
Managing Risk in the Housing Market Credit risk in housing finance means the risk that the borrower will default and the lender is not able to cover its losses by means of foreclosure. Intermediary credit risk is the risk of default of the financial intermediary that attracts financing for mortgage loans from the market (capital or deposit markets). Interest rate risk is the risk that interest rates will change, leading to another risk, prepayment risk, which occurs when the mortgage holder pays off all or some of the mortgage ahead of the maturity date impacting the timing and amount of cash flows. Liquidity risk refers to the inability to sell an asset for an expected price in order to obtain cash when necessary or to minimise claims severity in the case of a mortgage default. Securitisation of mortgage lending does not make the fundamental credit risk disappear, but simply distri butes this risk among various participants. Credit insurance covers some or all of a loan obligation when certain things happen to the mortgage borrower such as unemployment, disability, or death. There is also mortgage loan insurance which a mortgage borrower may be required by legislation to obtain from a mortgage loan insurance supplier to insure the lender against default. Mortgage loan insurance is mandated typically on high loan-to-value mortgages, where the borrower has less than predetermined downpayment, typically 20%. Mortgage loan insurance is fundamental to housing finance throughout the world and there are public and
International Housing Finance and Mortgage Securitisation In an international context, credit derivatives influence housing markets to support mortgage lending by way of better integration of housing finance with capital markets. The reason is that the structure of mortgage lending among international economies has often been plagued by a lack of domestic bank deposits to ensure adequate mortgage credit. Even when bank deposits are available competing investments are sometimes considered more optimal to allocate capital. These include commercial loans which are often distributed as demand loans with full recourse, based on variable loan rates and shorter terms than mortgage loans. Consumers may avoid bank deposits due to rates on saving account deposits com petition from mutual funds and retirement savings investments. This may constrain the amount of mortgage credit to consumers. The international expansion of securitisation is com plex. There is often no effective way to channel deposit savings into mortgages among many developed and developing economies. This reality has increased the global mortgage securitisation, linking the capital market with housing finance. The degree to which credit deriva tives are used flows from the requirements of financial institutions and investors to manage risks of holding mortgage assets. Credit derivatives are one of many
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tools used globally to provide credit enhancement for mortgage assets. Government guarantees on mortgage loans, mortgage loan insurance, and other tools either used separately, or in combination with credit derivatives, are necessary to meet investor requirements for credit enhancement. In the United States, there is a prominent role for gov ernment and government-sponsored enterprises (GSEs), such as Fannie Mae and Freddie Mac, to enhance credit and liquidity, facilitate mortgage securitisation, and expand homeownership as a national policy objective. (US GSEs Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation) were ‘nationalised’ on 7 September 2008 through a conser vatorship by the Federal Housing Finance Agency (FHFA) in response to the need for a liquidity injection to address the housing and mortgage market crisis in the United States.) The United States is the world’s largest mortgage market and has a developed MBS market in which GSEs guarantee and purchase mortgage assets. Credit derivatives can be a fundamental instrument to elevate the credit rating of mortgage pools to meet investor requirements, particu larly nontraditional mortgages that do not meet GSE guarantee requirements. In Canada, there is a state-owned mortgage insurer and guarantor, Canada Mortgage and Housing Corporation (CMHC), which manages most of the secur itisation of Canadian mortgages. CMHC operates in the secondary market through two programmes: MBS, which started in 1987, and the Canada Mortgage Bond (CMB) programme, which started in 2001. To be eligible for insured MBS or CMB, mortgages must be insured by way of federal statute, and this applies to all mortgages regardless of loan-to-value. In the case of CMB, the bonds are backed by pools of government-insured mortgages purchased by the Canada Housing Trust (CHT). The CHT was established in 2001 as a special purpose trust to purchase newly issued MBS pools and issue CMB, gaining the benefit of the government guarantee for mort gage loan insurance. This provides the basis for credit enhancement required by financial institutions and inves tors of Canadian mortgage assets. Canada’s approach is similar to that of both Japan, with the Government Home Loan Corporation, and Hong Kong, with the Hong Kong Mortgage Corporation. The government guarantee related to mortgage loan insurance is the dominant form of credit enhancement. Australia and the United Kingdom restrict government participation to enabling legislation to achieve a market allocation of resources. The credit enhancement of mort gage assets is considered more flexible, but also more complex. While the pool size can be managed through bundling of assets and closed-end investment funds are common, there is little standardisation of the structure of securitisation contract. Australia allows for assignment
programmes to pool mortgage loans on the balance sheet of a financial institution to an SPV. While some MBS is issued as a pass-through as in the United States, conduit programmes in Australia are the most common form of MBS, typically established by regional banks and financial intermediaries which lack the asset size to spon sor an assignment programme, without the credit support of a larger bank or facility provider. Among small finan cial institutions it is typical to warehouse mortgage pools until an adequate size is achieved to issue an MBS. The securitisation of residential mortgages in the United Kingdom, which started in 1985, is similar to that in Australia, as it also facilitated strong mortgage credit growth. Even though UK mortgages are tradition ally variable rate without prepayment penalties, a significant difference from North America, mortgage securitisation in the United Kingdom gained strong mar ket presence. By 2000 residential mortgage securitisation was ready to advance into other European markets as banks went global to attract investors such as pension funds, insurance companies, and investment funds seek ing high returns and diversification. The scale of residential mortgage securitisation in Europe has expanded. By 2008, there were a large number of market participants, including commercial banks of various sizes and monoline mortgage lenders. Many European nations such as Denmark, Finland, Germany, Spain, Sweden, and France have mortgage bond legislation, supported by the central bank and a state-owned mortgage insurer and bank. European gov ernments blend both direct and indirect actions to enhance mortgage lending, whereas the United States and Canada are more direct. For mortgage banks, covered mortgage bonds are an easy instrument to structure for residential mortgage lending, but require adequate pool size to achieve commercial attractiveness. Covered mort gage bonds are debt obligations issued by financial institutions for a pool of mortgages. They are subject to extensive statutory and supervisory regulation designed to protect covered bond investors from default risk. This legislative oversight has been generally lacking in the US mortgage system. The main challenge for many emerging market econo mies is the relatively low credit rating of the financial institutions originating the mortgage pools. The first MBS in Russia was in 2006 for US $88.3 million with loans originated by JSC Vneshtorgbank (VTB), Russia’s second largest bank. The credit enhancement for the 2006 VTB issue was provided by International Finance Corporation (IFC) in the form of a purchase of US $10.6 million Class B mezzanine notes. The active role of IFC as an investor, structurer, and credit enhancement provider assisted VTB in its goal to access long-term, cost-effective US dollar financing and to establish its name with European and US asset-backed investors. The increasing use of
Credit Derivatives and the Housing Market
credit ratings, credit scoring, and market-standard secur itisation structuring techniques by Russian originators is a necessary condition of financial intermediation in Russia. It is still a reality that many regional housing markets often lack data on property valuation and the credit worthiness of the underlying assets and borrowers may be difficult to evaluate. This may be due to incomplete mortgage loans origination systems and limitations in underwriting that fail to fully account for the credit worthiness of borrowers. There are even institutional shortcomings in some nations that lack a system of land titles and mortgage registration. This highlights the importance of credit derivatives within international mortgage securitisation to market mortgage pools to investors. However, credit derivatives may not be enough and there are some limitations as to the breadth of inter national investment permitted as well as policies on asset quality among some investment groups. Within the world banking community, securitisation is regarded as a way to not only enhance mortgage financing sources, as there is a limited retail deposit base, but also manage foreign exchange exposure and build global opportunities for growth. It is anticipated that a number of emerging economies will use residential mortgage securitisation to fill voids in retail lending directed towards housing finance to enhance homeownership. Government guarantees of mortgage pools; a combination of public and private mortgage loan insurance; and credit derivatives are considered essential for credit enhance ment. In addition, the IFC will likely play a central role in the provision of credit enhancement for mortgage pools originating in emerging economies.
Structured Finance The pricing of credit derivatives flows from the Black– Scholes option pricing model and the subsequent work of Robert Merton and others. The basis of this relation is the
fact that a mortgage is a portfolio of a risk-free bond and an option to default. It is thus relatively straightforward to extend the traditional option pricing framework to mort gages and other fixed income instruments subject to default risk. Prior to Merton’s 1974 work there was no systematic development of a theory for pricing bonds when there is a significant probability of default. Merton clarified and extended the Black–Scholes pricing model for options which at the time were just in their infancy in terms of importance as a financial instrument. Merton’s work used comparative statics to develop graphs of the risk structure. The pricing of corporate liabilities is there fore derived from observable inputs, namely (1) the required rate of return on riskless debt, (2) the various provisions and restrictions contained in the indenture, and (3) the probability that the firm will be unable to satisfy some or all of the indenture requirements. The market for credit derivatives has provided banks with new instruments for hedging and pricing loans. The link between credit default swaps and banks’ pricing of syndicated loans illustrate that monthly changes in credit default swap spreads are very significant in explaining loan spread changes of the subsequent month. Interest rate swaps and options along with crosscurrency swaps have grown in importance and size since 1987, representing 75% of the derivatives market. Credit default swaps increased from $630 billion in 2000 peaking to $62 trillion in 2007, as Figure 2 illus trates. The decline in the role of credit default swaps since 2007 highlights the market reality of the need to further restructure, refine, and regulate credit derivatives in general. The vast amount of credit derivatives outstanding is not indicative of the exposure that any financial institu tion may have as there are typically offsetting hedge positions through the equity markets and through the use of options and debt-related instruments as well as collateral held against the potential failure of counterparties. However, credit default swaps are unique in that
70 000 60 000 50 000 Notional amount in 40 000 billions of US 30 000 dollars 20 000 10 000 0 2001 - H1
2002 - H1
2003 - H1
273
2004 - H1
2005 - H1
2006 - H1
Credit default swaps Figure 2 Credit default swaps outstanding: Notional amounts – semi-annual data.
Source: International Swaps and Derivatives Association. ISDA market survey, 2009.
2007 - H1
2008 - H1
2009 - H1
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Credit Derivatives and the Housing Market
collateral requirements require a strong credit rating to be maintained by the party taking on the credit risk. A downgrade in credit rating to a credit default or bond insurer triggers a collateral call and this can be sudden and significant, at amounts which could exceed capital reserves of financial institutions underwriting the credit default swap. (Lehman Brothers had an estimated $350 billion in credit derivatives settlement claims as of October 2008. AIG entered into credit default swaps to guarantee collateral debt obligations resulting in a $85 billion bailout from the federal government. The main basis for the financial threat at AIG came from several sources: (1) a decline in real estate prices and increasing mortgage defaults that reduced the market value of mort gage-backed securities; (2) the loss in investment value that impacted AIG’s capital reserves, which would con strain AIG’s ability to cover outstanding credit default swaps; (3) the downgrading of AIG’s credit rating which triggered AIG’s collateralisation requirements, which were conditions of the credit default swap contracts; and (4) collateral requirements that exceeded AIG’s capital reserve and positioned AIG on the brink of collapse.) The weakness in the system is that while the financial institution that issues the credit default swap can imme diately recognise the premium to enhance the mortgage asset as income, it is not required to set aside an adequate capital reserve in the event of a settlement or collateral call. The financial incentive to write new credit default swaps can be suboptimal when there is no actuarial fund to secure the credit rating over time. The impact of this is heightened in the case of increasing mortgage defaults or other shocks that may impact the financial institution that issues credit default swaps.
Structured Housing Finance The expansion of MBS issuances integrated the mortgage market with the capital market and enlarged the base for mortgage credit. This was important in nations where banks had seen a decline in bank deposits due to a rise in competing investments such as mutual funds. Multipleclass MBSs, known as collateralised mortgage obligations (CMOs), and real estate mortgage investment certifi cates/conduits (REMICs) offered investors different levels of prepayment risk, which made them a better match for investors with varying asset-liability prefer ences. These innovations in MBS, along with increased capital incentives for banks due to Basel minimum capital requirements, caused the composition of pass-through securities to increase since the 1970s. (An agency passthrough security is structured so that even under the worst circumstances regarding prepayments, the interest and principal payments from the collateral will be suffi cient to meet the interest obligations of each tranche and
pay off the par value of each tranche. Defaults are ignored because the agency that has issued the pass-through used as collateral is expected to make up any deficiency.) MBS/CMO can either be by a government or government-sponsored • guaranteed (pass-through) agency (prior to September 2008,
•
neither Freddie Mac nor Fannie Mae guarantees are backed by the full faith of the US government; how ever, each entity has a line of credit to the US Treasury); or private, nonguaranteed.
A common type of securitisation transaction is referred to as a lender swap transaction. Mortgage lenders that oper ate in the primary mortgage market will deliver pools of mortgage loans in exchange for, for example, GSE MBS backed by these loans. A GSE establishes a trust and takes a fee (retention of interest) to guarantee that principal and interest will flow to third-party investors. Private, nonguaranteed MBS/CMO increased in the 1990s. Investors typically made a trade-off between the guarantee of agency-sponsored MBS/CMO against the high return of private MBS/CMO. Counterparty risk involved in MBS/ CMO comes from mortgage insurers; issuers, guarantors, and third-party providers of credit enhancements; mort gage investors; multifamily mortgage guarantors; and derivative counterparties. During the height of the subprime mortgage crisis in 2007, Freddie Mac reported ownership of almost $250 billion in nonagency MBSs; 27 different counterparties; and $1.3 trillion in derivatives largely to hedge benchmark interest rate risk. At the same time, Fannie Mae reported a $4.1 billion decline in the fair value of its derivatives (swap interest rates). A credit derivative is unfunded in the case of a direct transaction where credit protection is bought and sold between bilateral counterparties. A funded credit deriva tive is a case of structured finance where a financial institution or an SPV uses securitisation techniques, such that a debt obligation is issued by the financial institution or SPV to support these obligations. With GSE agency-sponsored MBS/CMO, investors do not bear credit risk and consumers benefit from lowcost mortgage loan rates. Nonagency MBS/CMO rely on subordinated tranches to provide credit loss protection, but still expose investors to institutional credit risk if the nature of the credit enhancement relies on a third-party credit default swap. Further protection comes by way of private bond insurance which had been rated AA or AAA, but in 2007 and 2008 bond insurers were downgraded by credit rating agencies (most notable was AIG’s credit rating downgrade three levels on 16 September 2008 due to mortgage-linked derivatives). In the case of subprime mortgage the issuer could sell a quantity of bonds less than the value of the underlying pool of assets to account for a higher than expected default rate.
Credit Derivatives and the Housing Market
This protection is called overcollateralisation, but in the case of US subprime mortgages, as there was no history of default statistics, this was not deemed necessary as often no difference was distinguished among quality of residential mortgage classes when subprime mortgage originations were at their height in 2006 (see Figure 6). However, since 2007 investors began to recognise a sub stantial difference in quality among mortgage classes as defaults increased for Alt-A and subprime mortgage products (Alt-A or A-Minus are typically defined as self-employed borrowers (no documentation to verify income) or new immigrants to the United States (no US credit history) whereas subprime borrowers have little or no credit (below a Fair Isaac Corporation credit bureau score, FICO, of 580–620)) (see Figure 6). In some instances, a spread account is used as a measure to further protect investors. With a spread account the MBS issuer would pay a lower interest rate to investors than earned by the underlying pool of mortgages. The funds in the spread account are used to guarantee payments to the various tranches, thereby reducing credit risk, allowing some mortgage assets to become nonperforming without impacting cash flows. Hedging instruments, such as options and futures, and institutions such as options and futures exchanges and clearinghouses allow financial institutions and investors to better manage cash flow risk from MBS/CMO. A decline in credit enhancements and credit downgrades used to support Alt-A and subprime mortgages restricts investment in the purchase of private MBS/CMO. Figure 3 overviews CMOs which package mortgage pools in very complex structures to match investor returns and cash flow needs. Credit derivatives are an integral part of making these investments function. CMOs are paid out subject to complex contracts. The senior tranche is represented by the highest credit rating,
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followed by the mezzanine tranche and finally the equity tranche. (It is apparent that credit rating agencies play a central role in the securitisation of mortgage assets as investors rely on accurate ratings as pension fund, endow ments, and other investment policies strictly set forth the quality and grade of debt investments that fund managers can invest in. In the context of risk management, the bulk of the risks under the securitisation system are transferred to investors. Lenders keep only the liquidity risk and this may be a problem. The limitation of securitisation from a risk management perspective is that investors cannot measure borrower credit risk, but rely on third-party rating agencies. However, the quality and timeliness of the credit ratings have come into question. This raises the potential for misrepresentation of mortgage loan applica tions since investors and third parties do not have a direct role in underwriting. This can increase the liquidity risk and counterparty risk to very high levels.) Credit default swaps enhance the credit rating of underlying mortgage assets to achieve investor requirements. This further adds to the complexity of the payout of many mortgage pools. Valuing and hedging MBS is important, but typical models for pricing and hedging MBS focus principally on the effect of interest rates on mortgage prepayment. While MBS prices are primarily sensitive to interest rate fluctuations, house price movements also have a signifi cant effect. Rising house prices stimulate mobility and may trigger prepayment. Conversely, falling house prices may trigger default. Prepayment and default must be regarded as substitutes when considering a model to price and hedge MBS. For example, a rise in the value of the default option must be accompanied by a fall in the value of the prepayment option. Support bonds absorb any principal prepayments that are made within a PAC tranche. However, when the support bonds are paid off due to prepayment, the PAC bonds schedule of planned
Credit Enhancement of Mortgage Assets:
Cash Flow Risks to Investors:
credit derivatives, credit default swaps, support bonds, mortgage loan insurance, indemnifications, collateralisation, and agency guarantee
complicated payoff rules, lack of comprehensive data on the loans in the pool, lack of agency guarantee, and counterparty risk
Mortgage assets in a SPV:
Senior tranche rated AA–AAA
$
Investors
Loans or obligations
Mezzanine tranche rated A–BB
$
Investors
SPV manager or trustee
Equity no rating
$
Figure 3 Collateral mortgage obligations packaging and payout on mortgage pools.
Investors
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Credit Derivatives and the Housing Market
payments will not likely be maintained. PAC class bonds use different prepayment protection strategies and these are compared by investors. Very accurately determined maturity bonds (VADMs) are supported by accrual or Z-bonds (Z because it is the last tranche to be paid out). In this instance, the interest that has accrued and not been paid out on a Z-bond protects the principal and interest on a VADM bond. In this regard the maximum final maturity can be deter mined in advance.
that increased private sector credit growth as noted in Figure 4. Mortgage credit is regarded as an important determi nant of the market demand for real estate. Deregulation, combined with phenomenal growth in the secondary mortgage sector, has resulted in a more liquid primary market that is now international in scope, as Figure 5 illustrates. When the mortgage market mirrors the vola tility of capital markets, lenders tend to offer significant front-end discounts on adjustable mortgages. (Financial market analysts often use the 10-year Treasury security rate as a surrogate for the long-term debt market. The size and liquidity of the Treasury market make it a good bellwether for other debt securities. Because Treasury bonds are free of default risk, the yield spread between mortgage rate and the 10-year Treasury rate is frequently used as a measure of the default risk premium on mort gages.) Overall, home price movements tend to track consumer credit levels.
Mortgage Credit and Housing Markets The synthetic securitisation process increased mortgage funding, particularly in the United States, the United Kingdom, and other European housing markets, with the most common being synthetic CDOs; credit-linked notes; single-tranche CDOs, and other similar products 30 25
IMF forecast Shaded area
United Kingdom
20 United States
15 10 5 Euro area
0 1980
1985
1990
1995
2000
2005
2010
–5 United States
United Kingdom
Euro area
Figure 4 Private sector credit growth. Borrowing as a percent of debt outstanding, quarter on quarter annualised, seasonally adjusted. Source: International Monetary Fund. Global Financial Stability Report, Financial Stress and Deleveraging, Macro-Financial Implications and Policy, 2008.
In billions of Euros 40 30 20 10
0 –10 2001
2002
2003
2004
2005
2006
2007
2008
–20 Figure 5 Euro area financial institution lending for house purchase.
Source: International Monetary Fund. Global Financial Stability Report, Financial Stress and Deleveraging, Macro-Financial Implications
and Policy, 2008.
Credit Derivatives and the Housing Market
Credit derivatives have fundamentally changed hous ing finance globally, and the underlying housing markets served by the respective national mortgage system. Innovative mortgage products supported by credit deri vatives have extended amortisations, kept downpayments to a minimum, and offered unique pricing features, to keep mortgage payments low.
The Complexities of Subprime Mortgage Lending There is a hope that credit derivatives and loan pricing are subject to rigorous and complex pricing models. However, what has become apparent with subprime lend ing is that mortgage borrowers at the lowest range of the credit scale pose a substantial credit risk. These borrowers were traditionally excluded from obtaining mortgage credit. In fact, subprime mortgage products were intro duced into housing finance without a history of credit default to ensure robust risk-based mortgage pricing. It may be that the secondary mortgage market and credit derivatives masked the problem, and combined with the US system of mortgage interest tax deductions, resulted in over-inflated US housing prices in markets exposed to subprime lending. The ABX Index is useful to consider as it tracks a series of credit default swaps based on 20 bonds that consist of subprime mortgages. ABX contracts are com monly used by investors to speculate on or to hedge against the risk that the underlying mortgage securities are not repaid as expected. The ABX swaps offer protec tion if the securities are not repaid as expected, in return for regular insurance-like premiums. A decline in the ABX Index signifies investor sentiment that subprime mortgage holders will suffer increased financial losses
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from those investments. Likewise, an increase in the ABX Index signifies investor sentiment looking for subprime mortgage holdings to perform better as investments. The ABX market illustrates that investors in mortgage pools can be exposed to potentially severe losses. The loss severity is large in a declining housing market where no- or low-credit-score mortgage borrowers with no downpay ment, adjustable-rate mortgage (ARM) products, and extended amortisations found themselves in a negative equity position with little incentive or ability to keep cur rent on mortgage payments. Subprime mortgage lending, which existed in only limited amounts until the late 1990s, exceeded 30% of mortgage loan originations in the United States by 2007 but only 5–10% in the markets of the United Kingdom, Australia, and Canada. The market reacted posi tively and more expeditiously than the regulators. As ABX market evidence indicates in Figure 6, investors became unwilling to hold subprime debt except at a deep discount during 2008. Financial institutions responded with a change to mortgage product offerings and more prudent under writing practices and credit-granting rules.
Are Credit Derivatives Destabilising to Housing Finance? The securitisation of mortgages is necessary for a wellfunctioning economy that supports homeownership. Credit derivatives are not destabilising, as these instru ments do offer financial institutions various methods for hedging and transferring credit risks. What is pro blematic is the terms of some derivatives contracts which are often opaque, unregulated, and difficult to track on corporate financial statements by credit ana lysts. What appears to be destabilising is the magnitude of subprime lending which resulted in the pooling and
Index = 100 120
100 80 60
ABX BBB (last paying tranche of subprime MBS)
40
ABX AAA (first paying tranche of subprime)
20 0 2006 Agency MBS
2007 Jumbo MBS
2008 Alt-A
ABX AAA
ABX BBB
Figure 6 Prices of US mortgage-related securities (in US dollars). Note: Jumbo MBS in the United States include mortgage loans with values in excess of $417 000 (continental US) and as of February 2008 jumbo loans were substantially increased in some jurisdictions. Source: International Monetary Fund. Global Financial Stability Report, Financial Stress and Deleveraging, Macro-Financial Implications and Policy, 2008.
278 Credit Derivatives and the Housing Market
selling of mortgages to third parties within a system of complex payout schemes leading to government fund ing support. Credit derivatives have come under scrutiny in recent years for a number of reasons: 1. The notional amount of financial instruments covered by over-the-counter derivatives exceeded $500 trillion by the end of 2008, according to the International Swaps and Derivatives Association (ISDA). 2. The settlement of credit derivative claims exposes potentially crippling losses to the impacted financial institutions, investors, and governments when there has not been a capital reserve set aside as part of the payment for the derivative (see Figure 7). 3. Public disclosure, comprehensive securitisation data, and regulatory oversight of credit derivatives have been lacking. 4. The decline in housing markets and rising default rate among mortgage markets coincided with a collapse in Alt-A and subprime MBS. Figure 7 summarises both US bank mortgage assets and the 2008 US Treasury funding commitments to stabilise these assets. The federal takeover of two US GSEs which are at the forefront of the US mortgage system, Fannie Mae and Freddie Mac, took place on 7 September 2008 when losses at the two GSEs approached $15 billion and the disruption of the US mortgage credit system was at its height. The conservatorship of these GSEs is one of the most significant nonmarket actions of nationalisation in US history, and is directly related to the subprime
mortgage market collapse. It was considered a necessary precondition by the US Treasury to commit up to $200 billion in preferred stock and extend credit through 2009 to keep the GSEs solvent to maintain mortgage credit for consumers. Between 2008 and 2010 the US Treasury extended $83.6 billion to Fannie Mae and $61.3 billion to Freddie Mac respectively, leading to an announcement in June 2010 by the FHFA that the shares of these GSEs be delisted from the New York Stock Exchange.
Legal Considerations Although beyond the scope of this article, credit deriva tives raise important legal considerations. For example, there are counterparty disputes where the seller of pro tection is trying to get out of its obligation to pay once a credit event occurs. There is also shareholder litigation where company shareholders that have entered into credit default swap contracts have had to make payments on the protection for which premiums were received, but claim that the company failed to disclose the risks posed by the credit default contracts. The US courts held in Aon Financial Products v. Socie´te´ Ge´ne´rale (476 F.3d 90, issued in 2007 by the Second Circuit Court of Appeals; it relates to the financing of a condominium project in the Philippines) that credit default swaps are private contracts and this case among others illustrates that financial insti tutions and hedge funds can be exposed to substantial losses even following rigorous attempts to balance positions.
Billions of US dollars
Percent of GDP
4500 4000
Investment bank (mortgages)
3500 30%
3000
Commercial bank (commercial mortgages)
20%
2500
Alt-A 10%
2000
Subprime GSE equity injection TARP asset purchase
Treasury MBS purchase
Prime
Commercial bank (residential mortgages)
1500 1000 500 0
Potential treasury funding commitments
US bank mortgage assets
Figure 7 Potential US commitment in the mortgage market, 2008 and 2009.
Source: International Monetary Fund. Global Financial Stability Report, Financial Stress and Deleveraging, Macro-Financial Implications
and Policy 2008. TARP: Troubled Asset Relief Program.
Credit Derivatives and the Housing Market
The legal specifics are even more complex as it becomes difficult to determine when a credit default swap contract legally triggers a credit default and payments are due to be made. The clearing of credit derivatives has become an important focus during the 2008 and 2009 financial crisis. Impacted financial institutions and inves tors commenced litigation to limit damages, claiming that there was misrepresentation and fraud during mortgage underwriting. Those who sold credit default swaps claim that these swaps are invalid if the mortgage origination was based on inaccurate property appraisals; false statements and omissions regarding borrower debt obligations; and unverified income for mortgage qualification.
Concluding Remarks The credit derivatives market serves housing finance with important financial instruments that support new and inno vative mortgage products and competitive mortgage loan rates. The consumer has benefited from the advances and changes to the mortgage system as homeownership rates in most nations have moved higher. Managing the fallout from failures in subprime mortgage lending is a challenging situation for financial institutions and regulators. Credit derivatives, although complex and not without inherent shortcomings as the housing finance and mortgage system continues to evolve, have yet to be perfected. There is a need for financial institutions that issue credit default swaps to properly recognise potential liabilities at origina tion and set aside an adequate capital reserve to settle collateral requirements to support nonperforming mortgage assets. Mortgage securitisation may look to the corporate bond market for changes, resulting in more homogeneous and therefore less complex contracts, larger pool sizes, and more comprehensive data. This will allow credit analysts and investors a better opportunity to participate. Agencysponsored CMO/MBS need to exercise prudence in terms of the mortgage products that qualify for these pools. Credit derivatives do not eliminate systematic risk in the economy and housing market downturns, and neither can they over come risky mortgage products or flaws in mortgage loan origination and underwriting which can be the target of misrepresentation and fraud. See also: Access and Affordability: Mortgage Guarantees; Government Mortgage Guarantee Institutions; Government Sponsored Enterprises in the United States; Mortgage Contracts: Flexible; Mortgage Contracts: Traditional; Mortgage Innovation; Mortgage
279
Insurance; Mortgage Market Functioning; Mortgage Market, Character and Trends: United States; Mortgage Payment Protection Insurance; Post-Bubble Housing in Japan; Subprime Mortgages.
Further Reading Black F and Scholes M (1973) The pricing of options and corporate liabilities. Journal of Political Economy 81: 637–654. Childs PD, Ott SH, and Riddiough TJ (1997) Bias in an empirical approach to determining bond and mortgage risk premiums. Journal of Real Estate Finance and Economics 14(3): 263–282. Downing C, Stanton R, and Wallace N (2005) An empirical test of a twofactor mortgage valuation model: How much do house prices matter? Real Estate Economics 33(4): 681–710. Duffie D (2008) Derivatives and mass financial destruction. Wall Street Journal October 22: A 17. Fabozzi F and Yuen D (1998) Managing MBS Portfolios. New Hope, PA: Frank J. Fabozzi Associates. Green R, Sanders AB, and Wachter S (2008) Special issue on subprime mortgage lending. Journal of Housing Economics 17(4): 253. Harrison DM, Noordewier TG, and Yavas A (2004) Do riskier borrowers borrow more? Real Estate Economics 32(3): 385–411. Haworth H, Reisinger C, and Shaw W (2008) Modelling bonds and credit default swaps using a structural model with contagion. Quantitative Finance 8(7): 669–680. International Monetary Fund (2008) World economic and financial surveys. World Economic Outlook: Financial Stress, Downturns, and Recoveries. October, Washington, DC: International Monetary Fund. International Swaps and Derivatives Association (2009) ISDA Market Survey. New York: ISDA. Merton R (1974) On the pricing of corporate debt: The risk structure of interest rates. Journal of Finance 29: 449–470. Mints V (2007) Securitization of mortgage loans as a housing finance system: To be or not to be. Housing Finance International December: 23–28. Mortgage Insurance Companies of America (2009) 2009–2010 Fact Book. September, Washington, DC: Mortgage Insurance Companies of America. Norden L and Wagner W (2008) Credit derivatives and loan pricing. Journal of Banking and Commerce 32: 2560–2569. Pavlov A and Wachter S (2006) The inevitability of market-wide underpricing of mortgage default risk. Real Estate Economics 34(4): 479–496. Shiller RJ (2008) The Subprime Solution: How Today’s Global Financial Crisis Happened, and What To Do about It. Princeton, NJ: Princeton University Press. Stiglitz JE and Weiss A (1981) Credit rationing in markets with imperfect information. American Economic Review 71: 393–410.
Relevant Websites www.fanniemae.com – Fannie Mae annual reports. www.freddiemac.com – Freddie Mac annual reports. www.ifc.org – International Finance Corporation. www.markit.com – Markit, the leading resource on the ABX market. www.isda.org – International Swaps and Derivatives Association for market date on credit default swaps.
Glossary Alt-A mortgage borrowers This class of mortgage borrowers includes new immigrants without a credit rating or self-employed individuals who cannot verify either employment or income; specific mortgage products exist for this borrower class. Collateral mortgage obligation This is a special purpose investment vehicle that as a legal entity owns mortgage assets within a pool. The mortgage assets represent the collateral and the mortgage pool provides cash flows for a bond issue sold to investors whereby specified tranches, for example senior, mezzanine, or equity, receive the distribution of cash flows subject to a contract which is referred to as the structure. Credit default swap This swap contract is an unfunded credit derivative that results in a buyer of the credit default swap making a series of payments to the seller of the credit default swap to obtain insurance-like protection in the event of a credit default. However, credit default swaps are not insurance since the buyer of the credit default swap does not need to own the underlying asset and the seller may not be a regulated entity and is not mandated to set aside a reserve fund from the premium payments to pay claims in the event of a credit default. Credit derivative This form of derivative is a bilateral contract and is negotiated over the counter, and not on an exchange, and is similar to other derivatives in that the seller of protection in a credit derivative contract receives premiums from the buyer of the protection until maturity, or until default, against the credit risk of the reference entity such as a mortgage pool. A credit derivative can be unfunded like a credit default swap or funded like collateralised debt obligations. Credit enhancement The purpose is to enhance the credit rating of an investment often fundamental to the securitisation transaction in structured finance. Similarly, it can reduce credit risk and provide, for
Housing Finance: Primary and Secondary Markets Homeownership is acknowledged globally to be a key factor in political and economic stability, according to the International Monetary Fund (IMF). Due to high land and construction costs relative to wages, homeownership requires a stable housing finance and mortgage system to succeed.
ECONOMICS/FINANCE
example, a lender or investor, with a guarantee of compensation if a borrower defaults by way of collateral, insurance, and/or some form of counterparty agreement. Credit risk Credit risk in housing finance means the risk that the mortgage borrower will default on a mortgage loan and the mortgage lender is not able to cover its loss due to foreclosure. Mortgage-backed security Referred to as MBS, this asset-backed security represents a claim on the principal and interest cash flows from a pool of mortgage loans originated from various financial institutions. MBS is typically sold as bonds and because mortgage borrowers can prepay mortgages there is the potential for prepayment risk. Credit risk also exists unless the mortgage assets are insured or guaranteed. Mortgage loan insurance On high loan-to-value mortgages, typically where the mortgage borrower does not have a 20% downpayment, there is often a legislative mandate to require mortgage loan insurance to be obtained from a mortgage loan insurance supplier. Mortgage loan insurance is also integral to MBS. The premium is paid to the insurance company at the time of mortgage funding to insure or guarantee the mortgage lender against loss due to foreclosure. Subprime mortgage lending The common misperception is that subprime mortgage borrowers can be defined by a type of mortgage product such as mortgages with zero downpayments, extended amortisations, or interest-only payments. Subprime mortgage borrowers are properly defined by their respective credit rating. A subprime mortgage borrower is someone that obtains a mortgage loan even though they have an impaired credit rating, usually due to a recent bankruptcy or when payments on personal debt obligations including taxes have been missed and are in arrears.
This reality seems to hold in any jurisdiction as reported by the IMF, and most new homebuyers seek out mortgages with terms of 15, 25, or more years and mortgages are often refinanced to pay for home maintenance, renovations, or other household consumption. The length of the mortgage amortisation period exposes borrowers to high interest costs and the potential for credit default is not insignificant as macroeconomic and personal fortunes can change.
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270
Credit Derivatives and the Housing Market
Table 1 Mortgage funding sources Retail
Wholesale
Primary funding Individual Bank Accounts Raised from companies and capital markets Current accounts Short call deposits Certificates of deposit Commercial paper Bonds Secondary funding Residential mortgage-backed securities Mortgage-backed bonds and structured covered bonds
In most mortgage systems, government-regulated len ders are responsible for origination, servicing, funding, and portfolio management of mortgage loans. The sources of funds for the mortgage loans are debt obligations of the lender. These obligations are in most cases deposits but may also be in the form of mortgage (or nonmortgage) bonds, dedicated savings, and loans from other financial institutions or from special liquidity (warehouse) facil ities, as outlined in Table 1. Basel I and II set forth minimum regulatory capital requirements that financial institutions must adhere to as part of credit risk management. The mandated minimum capital requirement in most nations therefore mortgage lending that is carried on the balance • limits sheet of a financial institution; whether financial institutions buy mortgage • influences loan insurance as this reduces or eliminates the capital
•
requirement for mortgages carried on the balance sheet; and results in a flow-through of mortgage loans into the secondary market, thus removing mortgage loans from the balance sheet.
Some mortgage lenders, which are referred to as monoline lenders, focus only on mortgage lending. They do not have funding available from retail sources and thus wholesale funding sources and securitisation are the only options to secure mortgage credit. Consolidating loans or other debt instruments into single assets or securities is called securitisation. The secondary mortgage market has evolved mortgage finance to a more specialised activity and the originator of the loan often does not hold it until maturity. Residential mortgage-backed securities (MBS or RMBS), collateral debt obligations (CDOs), and asset-backed commercial paper (ABCP) are bought and sold in financial markets much like stocks. These assets are transferred from the balance sheet of the mortgage originator to a company that is legally separate, called a special purpose vehicle (SPV). With an MBS, the originating firm retains any excess interest over the all-in cost of the securitisation but removes the loans and any associated capital require ment from its balance sheet. It is the SPV that acquires legal title to the mortgages and issues the MBS where it is managed with payments then made to investors based on the performance of the specific pool of mortgages. Figure 1 provides a graphic of a basic MBS. The cash flow from the mortgage pool is redistributed to the dif ferent tranches (known as ‘tranche’ from the French word for ‘slice’) based on a set of sequential payment rules, with Mortgage-backed securities are broken up into groups with investor cash flows derived from the original mortgage pool
Mortgage loan Senior secured
Mortgage loan
Last loss
Mortgage loan
Lowest risk
Mortgage loan Mortgage loan Mortgage loan
Special purpose vehicle:
Mortgage loan Mortgage loan Mortgage loan Mortgage loan
Pool of mortgage loans
Sale to investors at different levels of risk
Lowest Return Mezzanine Incur loss after Equity, but medium Risk and return Equity
Mortgage loan
Unsecured
Mortgage loan
First loss
Mortgage loan
High risk and return
Figure 1 Mortgage-backed securities. Collaterised mortgage obligations divide mortgage pool into tranches.
Credit Derivatives and the Housing Market
interest and principal paid starting with the senior secured. Prepayment of mortgage loans can alter cash flow into each tranche. Some MBSs use an accrual tranche when one or more tranches do not purposefully receive a payment in a particular period. Different variations of accrual tranches relate to changes in lending rates. Floating rate tranches are created from fixed rate tranches, with London Interbank Offered Rate (LIBOR) often used as the reference rate. Inverse floaters or stripped MBSs segregate the cash flows from the under lying security and provide investors with cash flow from either interest-only or principal-only components. There are modifiable and combinable features that provide investors with synthetic coupon options, an effective hedging tool. Planned amortisation class (PAC) bonds allow for the payment of a stream of principal amounts. Mortgage-backed bonds are secured debt securities issued by mortgage credit institutions supported by resi dential mortgages that remain on the balance sheet of the issuer. Individual mortgage-backed bonds can be substi tuted with other mortgage loans from the originator’s portfolio. There are some substitution limitations, such as the requirement for a match in terms of duration and quality of the mortgage asset.
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private suppliers of mortgage loan insurance. While it is a form of credit insurance, credit insurance is more often used to refer to policies that cover other kinds of debt. Insured mortgages serve mortgage systems by reducing or eliminating capital requirements, and MBS-insured mort gages provide an extra security to investors. The traditional view of lenders is that borrowers with out a credit history or lacking ability to manage debt are not suitable candidates for mortgages at any loan rate. The recent performance of US private mortgage loan insurance providers suggests that mortgage underwriting can be challenging in a weak housing market when bor rowers have little or negative home equity. Defaults for US insured mortgages among the largest mortgage insurers, with statistics tracked by the Mortgage Insurance Companies of America, ranged from between 210 000 and 350 000 per annum in the 1990s to more than 1 000 000 defaults in 2009. This is significant given that insured mortgages go through a dual underwriting pro cess whereby the originating lender underwrites the mortgage loan and then forwards this to a mortgage loan insurer that again underwrites the application (except in the case of delegated underwriting common in the United States) so as to validate the application and charge an appropriate insurance premium.
Managing Risk in the Housing Market Credit risk in housing finance means the risk that the borrower will default and the lender is not able to cover its losses by means of foreclosure. Intermediary credit risk is the risk of default of the financial intermediary that attracts financing for mortgage loans from the market (capital or deposit markets). Interest rate risk is the risk that interest rates will change, leading to another risk, prepayment risk, which occurs when the mortgage holder pays off all or some of the mortgage ahead of the maturity date impacting the timing and amount of cash flows. Liquidity risk refers to the inability to sell an asset for an expected price in order to obtain cash when necessary or to minimise claims severity in the case of a mortgage default. Securitisation of mortgage lending does not make the fundamental credit risk disappear, but simply distri butes this risk among various participants. Credit insurance covers some or all of a loan obligation when certain things happen to the mortgage borrower such as unemployment, disability, or death. There is also mortgage loan insurance which a mortgage borrower may be required by legislation to obtain from a mortgage loan insurance supplier to insure the lender against default. Mortgage loan insurance is mandated typically on high loan-to-value mortgages, where the borrower has less than predetermined downpayment, typically 20%. Mortgage loan insurance is fundamental to housing finance throughout the world and there are public and
International Housing Finance and Mortgage Securitisation In an international context, credit derivatives influence housing markets to support mortgage lending by way of better integration of housing finance with capital markets. The reason is that the structure of mortgage lending among international economies has often been plagued by a lack of domestic bank deposits to ensure adequate mortgage credit. Even when bank deposits are available competing investments are sometimes considered more optimal to allocate capital. These include commercial loans which are often distributed as demand loans with full recourse, based on variable loan rates and shorter terms than mortgage loans. Consumers may avoid bank deposits due to rates on saving account deposits com petition from mutual funds and retirement savings investments. This may constrain the amount of mortgage credit to consumers. The international expansion of securitisation is com plex. There is often no effective way to channel deposit savings into mortgages among many developed and developing economies. This reality has increased the global mortgage securitisation, linking the capital market with housing finance. The degree to which credit deriva tives are used flows from the requirements of financial institutions and investors to manage risks of holding mortgage assets. Credit derivatives are one of many
272
Credit Derivatives and the Housing Market
tools used globally to provide credit enhancement for mortgage assets. Government guarantees on mortgage loans, mortgage loan insurance, and other tools either used separately, or in combination with credit derivatives, are necessary to meet investor requirements for credit enhancement. In the United States, there is a prominent role for gov ernment and government-sponsored enterprises (GSEs), such as Fannie Mae and Freddie Mac, to enhance credit and liquidity, facilitate mortgage securitisation, and expand homeownership as a national policy objective. (US GSEs Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation) were ‘nationalised’ on 7 September 2008 through a conser vatorship by the Federal Housing Finance Agency (FHFA) in response to the need for a liquidity injection to address the housing and mortgage market crisis in the United States.) The United States is the world’s largest mortgage market and has a developed MBS market in which GSEs guarantee and purchase mortgage assets. Credit derivatives can be a fundamental instrument to elevate the credit rating of mortgage pools to meet investor requirements, particu larly nontraditional mortgages that do not meet GSE guarantee requirements. In Canada, there is a state-owned mortgage insurer and guarantor, Canada Mortgage and Housing Corporation (CMHC), which manages most of the secur itisation of Canadian mortgages. CMHC operates in the secondary market through two programmes: MBS, which started in 1987, and the Canada Mortgage Bond (CMB) programme, which started in 2001. To be eligible for insured MBS or CMB, mortgages must be insured by way of federal statute, and this applies to all mortgages regardless of loan-to-value. In the case of CMB, the bonds are backed by pools of government-insured mortgages purchased by the Canada Housing Trust (CHT). The CHT was established in 2001 as a special purpose trust to purchase newly issued MBS pools and issue CMB, gaining the benefit of the government guarantee for mort gage loan insurance. This provides the basis for credit enhancement required by financial institutions and inves tors of Canadian mortgage assets. Canada’s approach is similar to that of both Japan, with the Government Home Loan Corporation, and Hong Kong, with the Hong Kong Mortgage Corporation. The government guarantee related to mortgage loan insurance is the dominant form of credit enhancement. Australia and the United Kingdom restrict government participation to enabling legislation to achieve a market allocation of resources. The credit enhancement of mort gage assets is considered more flexible, but also more complex. While the pool size can be managed through bundling of assets and closed-end investment funds are common, there is little standardisation of the structure of securitisation contract. Australia allows for assignment
programmes to pool mortgage loans on the balance sheet of a financial institution to an SPV. While some MBS is issued as a pass-through as in the United States, conduit programmes in Australia are the most common form of MBS, typically established by regional banks and financial intermediaries which lack the asset size to spon sor an assignment programme, without the credit support of a larger bank or facility provider. Among small finan cial institutions it is typical to warehouse mortgage pools until an adequate size is achieved to issue an MBS. The securitisation of residential mortgages in the United Kingdom, which started in 1985, is similar to that in Australia, as it also facilitated strong mortgage credit growth. Even though UK mortgages are tradition ally variable rate without prepayment penalties, a significant difference from North America, mortgage securitisation in the United Kingdom gained strong mar ket presence. By 2000 residential mortgage securitisation was ready to advance into other European markets as banks went global to attract investors such as pension funds, insurance companies, and investment funds seek ing high returns and diversification. The scale of residential mortgage securitisation in Europe has expanded. By 2008, there were a large number of market participants, including commercial banks of various sizes and monoline mortgage lenders. Many European nations such as Denmark, Finland, Germany, Spain, Sweden, and France have mortgage bond legislation, supported by the central bank and a state-owned mortgage insurer and bank. European gov ernments blend both direct and indirect actions to enhance mortgage lending, whereas the United States and Canada are more direct. For mortgage banks, covered mortgage bonds are an easy instrument to structure for residential mortgage lending, but require adequate pool size to achieve commercial attractiveness. Covered mort gage bonds are debt obligations issued by financial institutions for a pool of mortgages. They are subject to extensive statutory and supervisory regulation designed to protect covered bond investors from default risk. This legislative oversight has been generally lacking in the US mortgage system. The main challenge for many emerging market econo mies is the relatively low credit rating of the financial institutions originating the mortgage pools. The first MBS in Russia was in 2006 for US $88.3 million with loans originated by JSC Vneshtorgbank (VTB), Russia’s second largest bank. The credit enhancement for the 2006 VTB issue was provided by International Finance Corporation (IFC) in the form of a purchase of US $10.6 million Class B mezzanine notes. The active role of IFC as an investor, structurer, and credit enhancement provider assisted VTB in its goal to access long-term, cost-effective US dollar financing and to establish its name with European and US asset-backed investors. The increasing use of
Credit Derivatives and the Housing Market
credit ratings, credit scoring, and market-standard secur itisation structuring techniques by Russian originators is a necessary condition of financial intermediation in Russia. It is still a reality that many regional housing markets often lack data on property valuation and the credit worthiness of the underlying assets and borrowers may be difficult to evaluate. This may be due to incomplete mortgage loans origination systems and limitations in underwriting that fail to fully account for the credit worthiness of borrowers. There are even institutional shortcomings in some nations that lack a system of land titles and mortgage registration. This highlights the importance of credit derivatives within international mortgage securitisation to market mortgage pools to investors. However, credit derivatives may not be enough and there are some limitations as to the breadth of inter national investment permitted as well as policies on asset quality among some investment groups. Within the world banking community, securitisation is regarded as a way to not only enhance mortgage financing sources, as there is a limited retail deposit base, but also manage foreign exchange exposure and build global opportunities for growth. It is anticipated that a number of emerging economies will use residential mortgage securitisation to fill voids in retail lending directed towards housing finance to enhance homeownership. Government guarantees of mortgage pools; a combination of public and private mortgage loan insurance; and credit derivatives are considered essential for credit enhance ment. In addition, the IFC will likely play a central role in the provision of credit enhancement for mortgage pools originating in emerging economies.
Structured Finance The pricing of credit derivatives flows from the Black– Scholes option pricing model and the subsequent work of Robert Merton and others. The basis of this relation is the
fact that a mortgage is a portfolio of a risk-free bond and an option to default. It is thus relatively straightforward to extend the traditional option pricing framework to mort gages and other fixed income instruments subject to default risk. Prior to Merton’s 1974 work there was no systematic development of a theory for pricing bonds when there is a significant probability of default. Merton clarified and extended the Black–Scholes pricing model for options which at the time were just in their infancy in terms of importance as a financial instrument. Merton’s work used comparative statics to develop graphs of the risk structure. The pricing of corporate liabilities is there fore derived from observable inputs, namely (1) the required rate of return on riskless debt, (2) the various provisions and restrictions contained in the indenture, and (3) the probability that the firm will be unable to satisfy some or all of the indenture requirements. The market for credit derivatives has provided banks with new instruments for hedging and pricing loans. The link between credit default swaps and banks’ pricing of syndicated loans illustrate that monthly changes in credit default swap spreads are very significant in explaining loan spread changes of the subsequent month. Interest rate swaps and options along with crosscurrency swaps have grown in importance and size since 1987, representing 75% of the derivatives market. Credit default swaps increased from $630 billion in 2000 peaking to $62 trillion in 2007, as Figure 2 illus trates. The decline in the role of credit default swaps since 2007 highlights the market reality of the need to further restructure, refine, and regulate credit derivatives in general. The vast amount of credit derivatives outstanding is not indicative of the exposure that any financial institu tion may have as there are typically offsetting hedge positions through the equity markets and through the use of options and debt-related instruments as well as collateral held against the potential failure of counterparties. However, credit default swaps are unique in that
70 000 60 000 50 000 Notional amount in 40 000 billions of US 30 000 dollars 20 000 10 000 0 2001 - H1
2002 - H1
2003 - H1
273
2004 - H1
2005 - H1
2006 - H1
Credit default swaps Figure 2 Credit default swaps outstanding: Notional amounts – semi-annual data.
Source: International Swaps and Derivatives Association. ISDA market survey, 2009.
2007 - H1
2008 - H1
2009 - H1
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Credit Derivatives and the Housing Market
collateral requirements require a strong credit rating to be maintained by the party taking on the credit risk. A downgrade in credit rating to a credit default or bond insurer triggers a collateral call and this can be sudden and significant, at amounts which could exceed capital reserves of financial institutions underwriting the credit default swap. (Lehman Brothers had an estimated $350 billion in credit derivatives settlement claims as of October 2008. AIG entered into credit default swaps to guarantee collateral debt obligations resulting in a $85 billion bailout from the federal government. The main basis for the financial threat at AIG came from several sources: (1) a decline in real estate prices and increasing mortgage defaults that reduced the market value of mort gage-backed securities; (2) the loss in investment value that impacted AIG’s capital reserves, which would con strain AIG’s ability to cover outstanding credit default swaps; (3) the downgrading of AIG’s credit rating which triggered AIG’s collateralisation requirements, which were conditions of the credit default swap contracts; and (4) collateral requirements that exceeded AIG’s capital reserve and positioned AIG on the brink of collapse.) The weakness in the system is that while the financial institution that issues the credit default swap can imme diately recognise the premium to enhance the mortgage asset as income, it is not required to set aside an adequate capital reserve in the event of a settlement or collateral call. The financial incentive to write new credit default swaps can be suboptimal when there is no actuarial fund to secure the credit rating over time. The impact of this is heightened in the case of increasing mortgage defaults or other shocks that may impact the financial institution that issues credit default swaps.
Structured Housing Finance The expansion of MBS issuances integrated the mortgage market with the capital market and enlarged the base for mortgage credit. This was important in nations where banks had seen a decline in bank deposits due to a rise in competing investments such as mutual funds. Multipleclass MBSs, known as collateralised mortgage obligations (CMOs), and real estate mortgage investment certifi cates/conduits (REMICs) offered investors different levels of prepayment risk, which made them a better match for investors with varying asset-liability prefer ences. These innovations in MBS, along with increased capital incentives for banks due to Basel minimum capital requirements, caused the composition of pass-through securities to increase since the 1970s. (An agency passthrough security is structured so that even under the worst circumstances regarding prepayments, the interest and principal payments from the collateral will be suffi cient to meet the interest obligations of each tranche and
pay off the par value of each tranche. Defaults are ignored because the agency that has issued the pass-through used as collateral is expected to make up any deficiency.) MBS/CMO can either be by a government or government-sponsored • guaranteed (pass-through) agency (prior to September 2008,
•
neither Freddie Mac nor Fannie Mae guarantees are backed by the full faith of the US government; how ever, each entity has a line of credit to the US Treasury); or private, nonguaranteed.
A common type of securitisation transaction is referred to as a lender swap transaction. Mortgage lenders that oper ate in the primary mortgage market will deliver pools of mortgage loans in exchange for, for example, GSE MBS backed by these loans. A GSE establishes a trust and takes a fee (retention of interest) to guarantee that principal and interest will flow to third-party investors. Private, nonguaranteed MBS/CMO increased in the 1990s. Investors typically made a trade-off between the guarantee of agency-sponsored MBS/CMO against the high return of private MBS/CMO. Counterparty risk involved in MBS/ CMO comes from mortgage insurers; issuers, guarantors, and third-party providers of credit enhancements; mort gage investors; multifamily mortgage guarantors; and derivative counterparties. During the height of the subprime mortgage crisis in 2007, Freddie Mac reported ownership of almost $250 billion in nonagency MBSs; 27 different counterparties; and $1.3 trillion in derivatives largely to hedge benchmark interest rate risk. At the same time, Fannie Mae reported a $4.1 billion decline in the fair value of its derivatives (swap interest rates). A credit derivative is unfunded in the case of a direct transaction where credit protection is bought and sold between bilateral counterparties. A funded credit deriva tive is a case of structured finance where a financial institution or an SPV uses securitisation techniques, such that a debt obligation is issued by the financial institution or SPV to support these obligations. With GSE agency-sponsored MBS/CMO, investors do not bear credit risk and consumers benefit from lowcost mortgage loan rates. Nonagency MBS/CMO rely on subordinated tranches to provide credit loss protection, but still expose investors to institutional credit risk if the nature of the credit enhancement relies on a third-party credit default swap. Further protection comes by way of private bond insurance which had been rated AA or AAA, but in 2007 and 2008 bond insurers were downgraded by credit rating agencies (most notable was AIG’s credit rating downgrade three levels on 16 September 2008 due to mortgage-linked derivatives). In the case of subprime mortgage the issuer could sell a quantity of bonds less than the value of the underlying pool of assets to account for a higher than expected default rate.
Credit Derivatives and the Housing Market
This protection is called overcollateralisation, but in the case of US subprime mortgages, as there was no history of default statistics, this was not deemed necessary as often no difference was distinguished among quality of residential mortgage classes when subprime mortgage originations were at their height in 2006 (see Figure 6). However, since 2007 investors began to recognise a sub stantial difference in quality among mortgage classes as defaults increased for Alt-A and subprime mortgage products (Alt-A or A-Minus are typically defined as self-employed borrowers (no documentation to verify income) or new immigrants to the United States (no US credit history) whereas subprime borrowers have little or no credit (below a Fair Isaac Corporation credit bureau score, FICO, of 580–620)) (see Figure 6). In some instances, a spread account is used as a measure to further protect investors. With a spread account the MBS issuer would pay a lower interest rate to investors than earned by the underlying pool of mortgages. The funds in the spread account are used to guarantee payments to the various tranches, thereby reducing credit risk, allowing some mortgage assets to become nonperforming without impacting cash flows. Hedging instruments, such as options and futures, and institutions such as options and futures exchanges and clearinghouses allow financial institutions and investors to better manage cash flow risk from MBS/CMO. A decline in credit enhancements and credit downgrades used to support Alt-A and subprime mortgages restricts investment in the purchase of private MBS/CMO. Figure 3 overviews CMOs which package mortgage pools in very complex structures to match investor returns and cash flow needs. Credit derivatives are an integral part of making these investments function. CMOs are paid out subject to complex contracts. The senior tranche is represented by the highest credit rating,
275
followed by the mezzanine tranche and finally the equity tranche. (It is apparent that credit rating agencies play a central role in the securitisation of mortgage assets as investors rely on accurate ratings as pension fund, endow ments, and other investment policies strictly set forth the quality and grade of debt investments that fund managers can invest in. In the context of risk management, the bulk of the risks under the securitisation system are transferred to investors. Lenders keep only the liquidity risk and this may be a problem. The limitation of securitisation from a risk management perspective is that investors cannot measure borrower credit risk, but rely on third-party rating agencies. However, the quality and timeliness of the credit ratings have come into question. This raises the potential for misrepresentation of mortgage loan applica tions since investors and third parties do not have a direct role in underwriting. This can increase the liquidity risk and counterparty risk to very high levels.) Credit default swaps enhance the credit rating of underlying mortgage assets to achieve investor requirements. This further adds to the complexity of the payout of many mortgage pools. Valuing and hedging MBS is important, but typical models for pricing and hedging MBS focus principally on the effect of interest rates on mortgage prepayment. While MBS prices are primarily sensitive to interest rate fluctuations, house price movements also have a signifi cant effect. Rising house prices stimulate mobility and may trigger prepayment. Conversely, falling house prices may trigger default. Prepayment and default must be regarded as substitutes when considering a model to price and hedge MBS. For example, a rise in the value of the default option must be accompanied by a fall in the value of the prepayment option. Support bonds absorb any principal prepayments that are made within a PAC tranche. However, when the support bonds are paid off due to prepayment, the PAC bonds schedule of planned
Credit Enhancement of Mortgage Assets:
Cash Flow Risks to Investors:
credit derivatives, credit default swaps, support bonds, mortgage loan insurance, indemnifications, collateralisation, and agency guarantee
complicated payoff rules, lack of comprehensive data on the loans in the pool, lack of agency guarantee, and counterparty risk
Mortgage assets in a SPV:
Senior tranche rated AA–AAA
$
Investors
Loans or obligations
Mezzanine tranche rated A–BB
$
Investors
SPV manager or trustee
Equity no rating
$
Figure 3 Collateral mortgage obligations packaging and payout on mortgage pools.
Investors
276
Credit Derivatives and the Housing Market
payments will not likely be maintained. PAC class bonds use different prepayment protection strategies and these are compared by investors. Very accurately determined maturity bonds (VADMs) are supported by accrual or Z-bonds (Z because it is the last tranche to be paid out). In this instance, the interest that has accrued and not been paid out on a Z-bond protects the principal and interest on a VADM bond. In this regard the maximum final maturity can be deter mined in advance.
that increased private sector credit growth as noted in Figure 4. Mortgage credit is regarded as an important determi nant of the market demand for real estate. Deregulation, combined with phenomenal growth in the secondary mortgage sector, has resulted in a more liquid primary market that is now international in scope, as Figure 5 illustrates. When the mortgage market mirrors the vola tility of capital markets, lenders tend to offer significant front-end discounts on adjustable mortgages. (Financial market analysts often use the 10-year Treasury security rate as a surrogate for the long-term debt market. The size and liquidity of the Treasury market make it a good bellwether for other debt securities. Because Treasury bonds are free of default risk, the yield spread between mortgage rate and the 10-year Treasury rate is frequently used as a measure of the default risk premium on mort gages.) Overall, home price movements tend to track consumer credit levels.
Mortgage Credit and Housing Markets The synthetic securitisation process increased mortgage funding, particularly in the United States, the United Kingdom, and other European housing markets, with the most common being synthetic CDOs; credit-linked notes; single-tranche CDOs, and other similar products 30 25
IMF forecast Shaded area
United Kingdom
20 United States
15 10 5 Euro area
0 1980
1985
1990
1995
2000
2005
2010
–5 United States
United Kingdom
Euro area
Figure 4 Private sector credit growth. Borrowing as a percent of debt outstanding, quarter on quarter annualised, seasonally adjusted. Source: International Monetary Fund. Global Financial Stability Report, Financial Stress and Deleveraging, Macro-Financial Implications and Policy, 2008.
In billions of Euros 40 30 20 10
0 –10 2001
2002
2003
2004
2005
2006
2007
2008
–20 Figure 5 Euro area financial institution lending for house purchase.
Source: International Monetary Fund. Global Financial Stability Report, Financial Stress and Deleveraging, Macro-Financial Implications
and Policy, 2008.
Credit Derivatives and the Housing Market
Credit derivatives have fundamentally changed hous ing finance globally, and the underlying housing markets served by the respective national mortgage system. Innovative mortgage products supported by credit deri vatives have extended amortisations, kept downpayments to a minimum, and offered unique pricing features, to keep mortgage payments low.
The Complexities of Subprime Mortgage Lending There is a hope that credit derivatives and loan pricing are subject to rigorous and complex pricing models. However, what has become apparent with subprime lend ing is that mortgage borrowers at the lowest range of the credit scale pose a substantial credit risk. These borrowers were traditionally excluded from obtaining mortgage credit. In fact, subprime mortgage products were intro duced into housing finance without a history of credit default to ensure robust risk-based mortgage pricing. It may be that the secondary mortgage market and credit derivatives masked the problem, and combined with the US system of mortgage interest tax deductions, resulted in over-inflated US housing prices in markets exposed to subprime lending. The ABX Index is useful to consider as it tracks a series of credit default swaps based on 20 bonds that consist of subprime mortgages. ABX contracts are com monly used by investors to speculate on or to hedge against the risk that the underlying mortgage securities are not repaid as expected. The ABX swaps offer protec tion if the securities are not repaid as expected, in return for regular insurance-like premiums. A decline in the ABX Index signifies investor sentiment that subprime mortgage holders will suffer increased financial losses
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from those investments. Likewise, an increase in the ABX Index signifies investor sentiment looking for subprime mortgage holdings to perform better as investments. The ABX market illustrates that investors in mortgage pools can be exposed to potentially severe losses. The loss severity is large in a declining housing market where no- or low-credit-score mortgage borrowers with no downpay ment, adjustable-rate mortgage (ARM) products, and extended amortisations found themselves in a negative equity position with little incentive or ability to keep cur rent on mortgage payments. Subprime mortgage lending, which existed in only limited amounts until the late 1990s, exceeded 30% of mortgage loan originations in the United States by 2007 but only 5–10% in the markets of the United Kingdom, Australia, and Canada. The market reacted posi tively and more expeditiously than the regulators. As ABX market evidence indicates in Figure 6, investors became unwilling to hold subprime debt except at a deep discount during 2008. Financial institutions responded with a change to mortgage product offerings and more prudent under writing practices and credit-granting rules.
Are Credit Derivatives Destabilising to Housing Finance? The securitisation of mortgages is necessary for a wellfunctioning economy that supports homeownership. Credit derivatives are not destabilising, as these instru ments do offer financial institutions various methods for hedging and transferring credit risks. What is pro blematic is the terms of some derivatives contracts which are often opaque, unregulated, and difficult to track on corporate financial statements by credit ana lysts. What appears to be destabilising is the magnitude of subprime lending which resulted in the pooling and
Index = 100 120
100 80 60
ABX BBB (last paying tranche of subprime MBS)
40
ABX AAA (first paying tranche of subprime)
20 0 2006 Agency MBS
2007 Jumbo MBS
2008 Alt-A
ABX AAA
ABX BBB
Figure 6 Prices of US mortgage-related securities (in US dollars). Note: Jumbo MBS in the United States include mortgage loans with values in excess of $417 000 (continental US) and as of February 2008 jumbo loans were substantially increased in some jurisdictions. Source: International Monetary Fund. Global Financial Stability Report, Financial Stress and Deleveraging, Macro-Financial Implications and Policy, 2008.
278 Credit Derivatives and the Housing Market
selling of mortgages to third parties within a system of complex payout schemes leading to government fund ing support. Credit derivatives have come under scrutiny in recent years for a number of reasons: 1. The notional amount of financial instruments covered by over-the-counter derivatives exceeded $500 trillion by the end of 2008, according to the International Swaps and Derivatives Association (ISDA). 2. The settlement of credit derivative claims exposes potentially crippling losses to the impacted financial institutions, investors, and governments when there has not been a capital reserve set aside as part of the payment for the derivative (see Figure 7). 3. Public disclosure, comprehensive securitisation data, and regulatory oversight of credit derivatives have been lacking. 4. The decline in housing markets and rising default rate among mortgage markets coincided with a collapse in Alt-A and subprime MBS. Figure 7 summarises both US bank mortgage assets and the 2008 US Treasury funding commitments to stabilise these assets. The federal takeover of two US GSEs which are at the forefront of the US mortgage system, Fannie Mae and Freddie Mac, took place on 7 September 2008 when losses at the two GSEs approached $15 billion and the disruption of the US mortgage credit system was at its height. The conservatorship of these GSEs is one of the most significant nonmarket actions of nationalisation in US history, and is directly related to the subprime
mortgage market collapse. It was considered a necessary precondition by the US Treasury to commit up to $200 billion in preferred stock and extend credit through 2009 to keep the GSEs solvent to maintain mortgage credit for consumers. Between 2008 and 2010 the US Treasury extended $83.6 billion to Fannie Mae and $61.3 billion to Freddie Mac respectively, leading to an announcement in June 2010 by the FHFA that the shares of these GSEs be delisted from the New York Stock Exchange.
Legal Considerations Although beyond the scope of this article, credit deriva tives raise important legal considerations. For example, there are counterparty disputes where the seller of pro tection is trying to get out of its obligation to pay once a credit event occurs. There is also shareholder litigation where company shareholders that have entered into credit default swap contracts have had to make payments on the protection for which premiums were received, but claim that the company failed to disclose the risks posed by the credit default contracts. The US courts held in Aon Financial Products v. Socie´te´ Ge´ne´rale (476 F.3d 90, issued in 2007 by the Second Circuit Court of Appeals; it relates to the financing of a condominium project in the Philippines) that credit default swaps are private contracts and this case among others illustrates that financial insti tutions and hedge funds can be exposed to substantial losses even following rigorous attempts to balance positions.
Billions of US dollars
Percent of GDP
4500 4000
Investment bank (mortgages)
3500 30%
3000
Commercial bank (commercial mortgages)
20%
2500
Alt-A 10%
2000
Subprime GSE equity injection TARP asset purchase
Treasury MBS purchase
Prime
Commercial bank (residential mortgages)
1500 1000 500 0
Potential treasury funding commitments
US bank mortgage assets
Figure 7 Potential US commitment in the mortgage market, 2008 and 2009.
Source: International Monetary Fund. Global Financial Stability Report, Financial Stress and Deleveraging, Macro-Financial Implications
and Policy 2008. TARP: Troubled Asset Relief Program.
Credit Derivatives and the Housing Market
The legal specifics are even more complex as it becomes difficult to determine when a credit default swap contract legally triggers a credit default and payments are due to be made. The clearing of credit derivatives has become an important focus during the 2008 and 2009 financial crisis. Impacted financial institutions and inves tors commenced litigation to limit damages, claiming that there was misrepresentation and fraud during mortgage underwriting. Those who sold credit default swaps claim that these swaps are invalid if the mortgage origination was based on inaccurate property appraisals; false statements and omissions regarding borrower debt obligations; and unverified income for mortgage qualification.
Concluding Remarks The credit derivatives market serves housing finance with important financial instruments that support new and inno vative mortgage products and competitive mortgage loan rates. The consumer has benefited from the advances and changes to the mortgage system as homeownership rates in most nations have moved higher. Managing the fallout from failures in subprime mortgage lending is a challenging situation for financial institutions and regulators. Credit derivatives, although complex and not without inherent shortcomings as the housing finance and mortgage system continues to evolve, have yet to be perfected. There is a need for financial institutions that issue credit default swaps to properly recognise potential liabilities at origina tion and set aside an adequate capital reserve to settle collateral requirements to support nonperforming mortgage assets. Mortgage securitisation may look to the corporate bond market for changes, resulting in more homogeneous and therefore less complex contracts, larger pool sizes, and more comprehensive data. This will allow credit analysts and investors a better opportunity to participate. Agencysponsored CMO/MBS need to exercise prudence in terms of the mortgage products that qualify for these pools. Credit derivatives do not eliminate systematic risk in the economy and housing market downturns, and neither can they over come risky mortgage products or flaws in mortgage loan origination and underwriting which can be the target of misrepresentation and fraud. See also: Access and Affordability: Mortgage Guarantees; Government Mortgage Guarantee Institutions; Government Sponsored Enterprises in the United States; Mortgage Contracts: Flexible; Mortgage Contracts: Traditional; Mortgage Innovation; Mortgage
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Insurance; Mortgage Market Functioning; Mortgage Market, Character and Trends: United States; Mortgage Payment Protection Insurance; Post-Bubble Housing in Japan; Subprime Mortgages.
Further Reading Black F and Scholes M (1973) The pricing of options and corporate liabilities. Journal of Political Economy 81: 637–654. Childs PD, Ott SH, and Riddiough TJ (1997) Bias in an empirical approach to determining bond and mortgage risk premiums. Journal of Real Estate Finance and Economics 14(3): 263–282. Downing C, Stanton R, and Wallace N (2005) An empirical test of a twofactor mortgage valuation model: How much do house prices matter? Real Estate Economics 33(4): 681–710. Duffie D (2008) Derivatives and mass financial destruction. Wall Street Journal October 22: A 17. Fabozzi F and Yuen D (1998) Managing MBS Portfolios. New Hope, PA: Frank J. Fabozzi Associates. Green R, Sanders AB, and Wachter S (2008) Special issue on subprime mortgage lending. Journal of Housing Economics 17(4): 253. Harrison DM, Noordewier TG, and Yavas A (2004) Do riskier borrowers borrow more? Real Estate Economics 32(3): 385–411. Haworth H, Reisinger C, and Shaw W (2008) Modelling bonds and credit default swaps using a structural model with contagion. Quantitative Finance 8(7): 669–680. International Monetary Fund (2008) World economic and financial surveys. World Economic Outlook: Financial Stress, Downturns, and Recoveries. October, Washington, DC: International Monetary Fund. International Swaps and Derivatives Association (2009) ISDA Market Survey. New York: ISDA. Merton R (1974) On the pricing of corporate debt: The risk structure of interest rates. Journal of Finance 29: 449–470. Mints V (2007) Securitization of mortgage loans as a housing finance system: To be or not to be. Housing Finance International December: 23–28. Mortgage Insurance Companies of America (2009) 2009–2010 Fact Book. September, Washington, DC: Mortgage Insurance Companies of America. Norden L and Wagner W (2008) Credit derivatives and loan pricing. Journal of Banking and Commerce 32: 2560–2569. Pavlov A and Wachter S (2006) The inevitability of market-wide underpricing of mortgage default risk. Real Estate Economics 34(4): 479–496. Shiller RJ (2008) The Subprime Solution: How Today’s Global Financial Crisis Happened, and What To Do about It. Princeton, NJ: Princeton University Press. Stiglitz JE and Weiss A (1981) Credit rationing in markets with imperfect information. American Economic Review 71: 393–410.
Relevant Websites www.fanniemae.com – Fannie Mae annual reports. www.freddiemac.com – Freddie Mac annual reports. www.ifc.org – International Finance Corporation. www.markit.com – Markit, the leading resource on the ABX market. www.isda.org – International Swaps and Derivatives Association for market date on credit default swaps.