Looking Beyond Credit Ratings: Factors Investors Consider In Pricing European Asset‐Backed Securities

In this paper, we empirically investigate what credit factors investors rely upon when pricing the spread at issue for European asset‐backed securities. More specifically, we investigate how credit factors affect new issuance spreads after taking into account credit rating. We do so by investigating primary market spreads for tranches of non‐mortgage‐related asset‐backed securities issued from 1999 to the year prior to the subprime mortgage crisis, 2007. We find that although credit ratings play a major role in determining spreads, investors appear to not rely exclusively on these ratings. Our findings strongly suggest that investors do not ignore other credit factors beyond the assigned credit rating.     

Are covered bonds different from securitization bonds? A comparative analysis of credit spreads

This study compares credit spreads and pricing determinants of securitization vis-à-vis covered bonds. Our analysis reveals that although ratings are the most important pricing determinant for asset-backed securities (ABS) and mortgage-backed securities (MBS) investors place relatively more importance on contractual, macroeconomic and banks' characteristics rather than ratings in pricing covered bonds. We find evidence of a mispricing effect in structured finance markets: ABS and MBS have higher credit spreads than similarly rated public-covered bonds and mortgage-covered bonds and security prices reflect information beyond credit ratings. We find no evidence of borrowing costs affecting banks' choice between securitization and covered bonds.     

GSEs,Mortgage Rates,and Secondary Market Activities

Fannie Mae and Freddie Mac are government-sponsored enterprises (GSEs) that securitize mortgages and issue mortgage-backed securities (MBS). In addition, the GSEs are active participants in the secondary mortgage market on behalf of their own investment portfolios. Because these portfolios have grown quite large, portfolio purchases (in addition to MBS issuance) are often thought to be an important force in the mortgage market. Using monthly data from 1993 to 2005 we estimate a VAR model of the relationship between GSE secondary market activities and mortgage interest rate spreads. We find that GSE portfolio purchases have no significant effects on either primary or secondary mortgage rate spreads. Further, we examine GSE activities and mortgage rate spreads in the wake of the 1998 debt crisis, and find that GSE portfolio purchases did little to affect mortgage rates. This empirical finding is robust to alternative identification assumptions and to alternative model and variable specifications.      

Analysis of REIT IPOs Using a Market Microstructure Approach: Anomalous Behavior or Asset Structure

In this research, we examine and present new evidence on the market activity following the initial public offering (IPO) of a real estate investment trust (REIT) using microstructure data. We analyze the bid-ask spread differences for REIT securities compared to common stocks and closed-end funds for all IPOs between 1985 and 1988. Our results show that REITs, as a whole sample, experience significantly greater bid-ask spreads immediately following the IPO compared to common stocks and funds. However, this outcome is driven by the equity REIT sample, with the mortgage REIT sample having significantly smaller bid-ask spreads. This is in contrast to the evidence documented by Nelling, Mahoney, Hildebrand, and Goldstein (1995). We attribute our result to the underlying asset structure (such as equity, hybrid, and mortgage portfolios) of the various REITs. Overall, however, we find that bid-ask spreads for REITs are similar to those of common stock when both asset structure and the traditional determinants of the spread (share price, trade volume, and returns variance) are considered.     

PREPAYMENT RISK AND THE DURATION OF DEFAULT-FREE MORTGAGE-BACKED SECURITIES

The conventional duration measure for mortgage-backed pass-through securities assumes that the prepayment rate is invariant to changes in market interest rates. In this paper, the conventional duration is modified to take into account the interest-rate sensitivity of mortgage prepayments. Including interest rate sensitivity is shown to reduce substantially the duration of a mortgage-backed pass-through security when the current mortgage rate is less than the contract rate.     

Securitization markets and central banking: An evaluation of the term asset-backed securities loan facility

In response to the near collapse of US securitization markets in 2008, the Federal Reserve created the Term Asset-Backed Securities Loan Facility, which offered non-recourse loans to finance investors’ purchases of certain highly rated asset-backed securities. We study the effects of this program and find that it lowered interest rate spreads for some categories of asset-backed securities but had little impact on the pricing of individual securities. These findings suggest that the program improved conditions in securitization markets but did not subsidize individual securities. We also find that the risk of loss to the US government was small.     

An Empirical Investigation of Alternative Contingent Claims Models for Pricing Residential Mortgages

Researchers have employed option pricing techniques to analyze mortgage financing and valuation. Alternative models (one-, two-, and three-variable models) employing different variables (short- and long-term interest rates and building value) have been designed to price mortgage securities. No prior research has addressed the question of whether the pricing accuracy of these contingent claims models improves as states increase or whether contingent claims models' valuation abilities generate reasonable estimates of primary mortgage market prices. The articles investigates the relative efficiency of each of these alternative mortgage valuation models in predicting primary market mortgage values. Our results show that a two-variable model (short rate and building value) is the most efficient. Valuation results indicate a positive pricing spread between the primary market and the theoretically estimated value.     

Valuation of GNMA Mortgage-Backed Securities

GNMA mortgage-backed pass-through securities are supported by pools of amortizing, callable loans. Additionally, mortgagors often prepay their loans when the market interest rate is above the coupon rate of their loans. This paper develops a model for pricing GNMA securities and uses it to examine the impact of the amortization, call, and prepayment features on the prices, risks and expected returns of GNMA's. The amortization and prepayment features each have a positive effect on price, while the call feature has a negative impact. All three features reduce a GNMA security's interest rate risk and, consequently, its expected return.     

Pricing mortgages: An interpretation of the models and results

Mortgages, like all debt securities, can be viewed as risk-free assets plus or minus contingent claims that can be usefully viewed as options. The most important options are: prepayment, which is a call option giving the borrower the right to buy back the mortgage at par; and default, which is a put option giving the borrower the right to sell the house in exchange for the mortgage. This article reviews and interprets the large and growing body of literature that applies recent results of option pricing models to mortgages. We also provide a critique of the models and suggest directions for future research.The Ohio State University and the National Bureau of Economic ResearchThe Urban Institute University of California at Los Angeles     

The effect of large investors on asset quality: Evidence from subprime mortgage securities

Fannie Mae and Freddie Mac (the GSEs), the dominant investors in subprime mortgage-backed securities before the 2008 crisis, substantively affected collateral composition in this market. Mortgages included in securities designed for the GSEs performed better than those backing other securities in the same deals, holding observable risk constant. Consistent with the transmission of private information, these effects are concentrated in low-documentation loans and for issuers that were highly dependent on the GSEs and were corporate affiliates of the mortgage originators. Additional analysis of yield spreads shows that these performance differences were not reflected in prices.     

Trustee reputation in securitization: When does it matter?

We consider the role of trustees–who are nominated to protect the interests of investors–in securitization pricing and whether investors rely on them to mitigate risks. In particular, we examine the effect of trustee reputation on initial yield spreads of European mortgage‐backed security (MBS) issuances between 1999 and the first half of 2007. We find that engaging reputable trustees led to lower spreads during the credit boom period prior to the 2007–2009 financial crisis. Our findings suggest that trustees’ reputation was considered by investors to be more important when risk assessment became more challenging.     

The refinancing threshold pricing model: An economic approach to valuing MBS

Investigation of MBS prepayment data indicates that mortgagors have different interest rate levels, or thresholds, at which they exercise their option to prepay their mortgage. In order to properly value an MBS with heterogeneous mortgagors, Merrill Lynch has developed the Refinancing Threshold Pricing Model (RTP). The RTP model focuses on the refinancing decision of the mortgagor when pricing the mortgage pool. The model divides each pool into groups of mortgagors who share similar refinancing costs. Using market data, the RTP model endogenously determines both the implied costs that mortgagors face, as well as the proportion of the MBS pool in each refinancing cost group. In addition to determining pool value, the RTP model also calculates MBS duration, dP/dY and convexity. Comparison between RTP model values and actual market data reveals a strong correlation. The RTP has a wide range of applications, including valuing 15-year and 30-year conventional MBS; pricing interest-only (IO)/principal-only (PO) derivative MBS; determining new versus seasoned MBS price spreads; and valuing specific MBS pools.The information set forth was obtained from sources we believe reliable, but we do not guarantee its accuracy. Neither the information, nor any opinion expressed constitutes a solicitation by us for the purchase or sale of any securities or commodities. Merrill Lynch, Pierce, Fenner & Smith, Inc. or its affiliates may have either a long or short position in, and may buy and sell for its own account or the accounts of others, these securities.     

A comparative analysis of ex ante credit spreads: Structured finance versus straight debt finance

This paper examines the pricing of structured finance (SF) – asset-backed securities (ABS), mortgage-backed securities (MBS), and collateralized debt obligations (CDO) – and straight debt finance transactions. Using a cross-section of 24,525 European bonds issued by financial and nonfinancial firms in the 2000–2016 period, we show that although ratings are the most important pricing determinant for SF and corporate bonds (CB) at issuance, investors rely on other contractual, macroeconomic, and firms’ characteristics beyond these ratings. We find that CDO tranches have, on average, higher credit spreads than similarly rated CB, while investors are not compensated for facing higher systematic risk components in relation to investment-grade ABS and MBS. Our results also support the hypothesis of SF transactions as mechanisms of reducing funding costs: SF transactions’ weighted average spread is lower than that of comparable CB and originating firms’ creditworthiness does not deteriorate when compared to a sample of matched firms.     

Unintended Consequences of Risk Based Pricing: Racial Differences in Mortgage Costs

The following analysis focuses on the role that risk pricing has had in the allocation and access to mortgage funds, specifically how it results in cost differences by race. Using a sample of fixed-rate first lien mortgages, we control for the risk characteristics of borrowers and assets. We find that borrowers with comparable credit quality experience significantly higher costs for mortgages in neighborhoods with a high density of minority households. Further, when the pricing differential is controlled for in a model of mortgage default, there is no support for neighborhood price differences. This finding illustrates a potential inequity that results from efficient/risk pricing in mortgage underwriting.     

The composition of CMBS risk

This paper identifies the put-option, liquidity availability proportion, and shadow liquidity risk premia embedded within commercial mortgage backed securities (CMBS) using reduced form and structural generalization models. These risk values are then interpreted as trading signals which are tested with automated trading strategies that buy undervalued and sell overvalued CMBS from November 2007 through June 2015. All three signals generate substantial positive trading profits in testing for the reduced form model but not for the structural generalization. The risk signals constructed independently of market pricing provide more profitable automated trading insights than those constructed from interactions between modeled risk measures and market spreads. In my tests of the information content of the risk signals with respect to future macroeconomic indicators, I find statistically significant evidence in keeping with recent studies. While I cannot reject CMBS efficiency, this paper’s disclosure of new risk measures, the profitability of automated strategies based on those risk measures, and the statistical significance of their forward guidance capabilities, together contributes to our understanding of CMBS risk and the credit spread puzzle debate.     

Monetary policy transparency and pass-through of retail interest rates

This paper examines the degree of pass-through and adjustment speed of retail interest rates in response to changes in benchmark market rates in New Zealand during the period 1994–2004. We consider the effects of policy transparency and financial structure of the monetary transmission mechanism. New Zealand is the first OECD country to adopt a full-fledged inflation targeting regime with specific accountability and transparency provisions. Policy transparency was further enhanced by a shift from quantity (settlement cash) to price (interest rate) operating targets in 1999. Using Phillips–Loretan estimates of cointegrating regressions we find complete long-term pass-through for some but not all retail rates. Our results also show that the introduction of the Official Cash Rate (OCR) increased the pass-through of floating and deposit rates but not fixed mortgage rates. In line with previous studies we find the immediate pass-through of market interest rates to bank retail rates to be incomplete. Although we find no statistical evidence for asymmetric response of retail rates to changes in market rates other than for business lending rates in the pre OCR period, differences in the magnitude of mean adjustment lags indicate that banks appear to pass on decreases to fixed mortgage rates faster. Overall, our results confirm that monetary policy rate has more influence on short-term interest rates and that increased transparency has lowered instrument volatility and enhanced the efficacy of policy.     

A Simple Approach to Valuing Risky Fixed and Floating Rate Debt

We develop a simple approach to valuing risky corporate debt that incorporates both default and interest rate risk. We use this approach to derive simple closed-form valuation expressions for fixed and floating rate debt. The model provides a number of interesting new insights about pricing and hedging corporate debt securities. For example, we find that the correlation between default risk and the interest rate has a significant effect on the properties of the credit spread. Using Moody's corporate bond yield data, we find that credit spreads are negatively related to interest rates and that durations of risky bonds depend on the correlation with interest rates. This empirical evidence is consistent with the implications of the valuation model.     

Commercial Mortgage-Backed Securities: Prepayment and Default

One of the major developments in real estate finance during the 1990s was the emergence of a viable market for commercial mortgage backed securities. The growth in this market has spurred greater interest in empirical and theoretical research on commercial mortgage default and prepayment. We employ a competing risks model to examine the default and prepayment behavior of commercial loans underlying CMBS deals. We find that changes in the yield curve have a direct impact on the probability of mortgage termination. Furthermore, we do not find any statistical relationship between LTV and prepayment or default.     

On Jumps in Common Stock Prices and Their Impact on Call Option Pricing

The Black-Scholes call option pricing model exhibits systematic empirical biases. The Merton call option pricing model, which explicitly admits jumps in the underlying security return process, may potentially eliminate these biases. We provide statistical evidence consistent with the existence of lognormally distributed jumps in a majority of the daily returns of a sample of NYSE listed common stocks. However, we find no operationally significant differences between the Black-Scholes and Merton model prices of the call options written on the sampled common stocks.