CDO Market Implosion and the Pricing of Subprime Mortgage-Backed Securities

Yongheng Deng, Stuart A. Gabriel, Anthony B. Sanders
2009 Social Science Research Network  
The global market for collateralized debt obligations (CDOs) witnessed explosive growth over the 1997-2006 period, as the stock of global issuance expanded from $300 billion to almost $2 trillion. CDO issuance importantly supported the market for subprime mortgage-backed debt, via the re-packaging of those assets into derivative CDO securities. The surge in issuance of subprime mortgage-backed CDOs coincided with a marked tightening in subprime MBS-Treasury spreads, suggesting some measurable
more » ... fect of this market-completing vehicle on the supply/demand balance and pricing of mortgage-backed securities. In 2007 and in the wake of the implosion in the CDO market, spreads on subprime mortgage-backed securities widened considerably. This research evaluates the effects of the emergence of the CDO market on the pricing of subprime residential mortgage-backed securities. Upon controlling for mortgage option values and other well-established determinants of credit spreads, research indicates that the emergence of the subprime-backed CDO market was associated with a significant tightening of subprime MBS/Treasury yield spreads. Results of VAR and other robustness tests serve to corroborate the results. Research findings suggest the importance of innovations in derivative securities markets to the pricing and related affordability of subprime mortgages. Results similarly indicate that the unexpected closure of the CDO market exerted upward pressure on MBS spreads, and in so doing contributed to changes in the pricing, underwriting and related demise of subprime mortgages. JEL Classification Numbers: R31, G10, G12
doi:10.2139/ssrn.1356630 fatcat:5pdu4w2egba2nn6vzgyzoxkgm4