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MBS ratings and the mortgage credit boom
Adam Ashcraft (New York Fed)Paul Goldsmith‐Pinkham (Harvard University, HBS)James Vickery (New York Fed)
Bocconi / CAREFIN Banking ConferenceSeptember 21, 2009p ,
Views expressed in this presentation are our own and do not reflect the opinions of the
for internal use only
Views expressed in this presentation are our own, and do not reflect the opinions of the Federal Reserve Bank of New York or the Federal Reserve System.
Net ratings downgrades: average number of notches10
Alt-A Subprime
(not
ches
)5
dow
ngra
de
Net
ratin
g 0
2001q1 2003q1 2005q1 2007q1 2001q1 2003q1 2005q1 2007q1Calendar quarter of deal securitization
2for internal use only
Source: Authors calculations based on ABSNet and Bloomberg
Calendar quarter of deal securitization
This paper
Study credit ratings on subprime and Alt‐A MBS deals issued in the period leading up to the financial crisis (2001‐07).
Research question: To what extent were ratings flawed ex‐ante? Do observed outcomes just reflect an “unlucky” realization of fundamentals ex‐post?
Two types of analysis:
1. Determinants of credit ratings. How do ratings evolve through time, conditional on risk?
2. Relationship between ratings and realized deal performance. How well did ratings summarize available information?
3for internal use only
Ratings errors: Bad luck or bad modelling?
“In response to the increase in the riskiness of loans made during the last few years and the changing economic environment, M d ’ t dil i d it l t ti d b tMoody’s steadily increased its loss expectations and subsequent levels of credit protection on pools of subprime loans. Our loss expectations and enhancement levels rose by about 30% over the 2003 to 2006 time period…”
“Along with most other market participants, however, we did notAlong with most other market participants, however, we did not anticipate the magnitude and speed of the deterioration in mortgage quality (particularly for certain originators) or the rapid transition to restricti e lending ”transition to restrictive lending.”
‐Michael Kanef, Moodys executive/ /
4for internal use only
Senate testimony, 9/26/07
Main findings
1. Time‐variation in ratings, with deterioration in standards at end of mortgage credit boom (2005‐07).
Deals become progressively riskier between 2005‐07, but ratings stay flat during this period.
2. Ratings not sufficiently sensitive to credit risk.
We construct a simple summary statistic for the credit risk of p yeach deal. This variable strongly predicts worse performance (defaults, losses, rating downgrades), conditional on rating.
Implication: High‐risk deals were over‐rated. Ratings not a “sufficient statistic” for level of credit risk in the deal.
Results stronger for Alt A deals and deals with high fraction of
5for internal use only
Results stronger for Alt‐A deals and deals with high fraction of low doc loans, where opacity is arguably greater.
Related Literature
Theoretical work on credit rating agencies (CRAs)Mathis, McAndrews and Rochet (JME, forthcoming): Dynamic setting, reputation cycles in credit ratings.
Bolton, Freixas and Shapiro (2008); Sangiorgi, Sokobin and Spatt (2009); Mariano (2008); Skreta and Veldkamp (2008) etcSpatt (2009); Mariano (2008); Skreta and Veldkamp (2008) etc.
Empirical evidence on credit ratings:
N d ld d Sh l d (2008) Ki d S h (2009)Nadauld and Sherlund (2008); Kisgen and Strahan (2009); Becker and Milbourn (2008); Benmelech and Dlugosz (2009); Mason and Rosner (2007); Griffin and Tang (2009). etc.
Related work on the subprime crisis:
Stanton and Wallace (2009); Coval Jurek and Stafford (2008);
6for internal use only
Stanton and Wallace (2009); Coval, Jurek and Stafford (2008); Ashcraft and Schuermann (2008); Gorton (2008). etc.
What is a credit rating?
Ordinal measure of credit risk on a debt securityS&P and Fitch: Rating measures the “probability of default”.g p y
Moody's: Closer to a measure of “expected loss”.
Our primary measure of ratings: AAA subordination Our primary measure of ratings: AAA subordinationFraction of claims on the deal that receive a rating below AAA. Also known as the “AAA attachment point”.
Note: this measure is continuous, even though rating on h i di id l b d i di t
7for internal use only
each individual bond is discrete.
Data: Nonagency deals3,144 Alt‐A and subprime deals
59,995 securities
MortgagePools
RMBSBonds
REMICTrust
Individual Mortgages
M1 M2 M3 M4 M5 M6 M7 M8 M9 M10
2/28Hybrid ARM
‘AAA’RMBS
M11 M12 M13 M14 M15 M16 M17 M18 M19 M20
M21 M22 M23 M24 M25 M26 M27 M28 M29 M30
M31 M32 M33 M34 M35 M36 M37 M38 M39 M40Hybrid ARMMortgage
Pool
RMBS
SpecialPurposeVehicle
M41 M42 M43 M44 M45 M46 M47 M48 M49 M50
M51 M52 M53 M54 M55 M56 M57 M58 M59 M60
M61 M62 M63 M64 M65 M66 M67 M68 M69 M70
‘AA’RMBS
‘A’RMBS
‘BBB’
(RMBSTrust)M71 M72 M73 M74 M75 M76 M77 M78 . . .
M2000
M1 M2 M3 M4 M5 M6 M7 M8 M9 M10
M11 M12 M13 M14 M15 M16 M17 M18 M19 M20
Fixed RateMortgage
BBBRMBS
‘BBB‐’RMBS
Residual
M11 M12 M13 M14 M15 M16 M17 M18 M19 M20
M21 M22 M23 M24 M25 M26 M27 M28 M29 M30
M31 M32 M33 M34 M35 M36 M37 M38 . . .
M1000
8for internal use only
es dua1000
Source: Gorton (2008)
ABSNet / BloombergLoanPerformance ( 11m loans)
Summary statisticsS b i Al A AllSubprime Alt‐A All
Number of deals 1607 1537 3144Deal size, mean ($m) 896 595 749Deal si e median ($m) 790 487 631Deal size, median ($m) 790 487 631Total number of securities 26430 33525 59955Securities per deal, median 17 19 18AAA securities per deal median 5 10 6AAA securities per deal, median 5 10 6
Credit enhancementMean fraction of AAA securities 82.38 93.07 87.61Percent of deals with bond insurance 14 0 8 8 11 5Percent of deals with bond insurance 14.0 8.8 11.5Average value of insurance (%FV) 5.0 1.9 3.5Excess spread at origination (%), avg 4.1 1.4 2.8
Number of CRAs that rated deal (%)Number of CRAs that rated deal (%)One 0.3 0.4 0.3Two 48.1 83.0 65.1Three 45 1 16 5 31 1
9for internal use only
Three 45.1 16.5 31.1Four 6.5 0.2 3.4
Non‐agency MBS issuance
150
150
Subprime
150
150
Alt-A
100
100
100
100
5050#
of D
eals
505055 55
00
2001
q1
2002
q1
2003
q1
2004
q1
2005
q1
2006
q1
2007
q1
2008
q1
2009
q1
Year-Quarter
# of Deals Orig. Amt ($ Bn)
00
2001
q1
2002
q1
2003
q1
2004
q1
2005
q1
2006
q1
2007
q1
2008
q1
2009
q1
Year-Quarter
# of Deals Orig. Amt ($ Bn)
10for internal use only
IMF Volume ($ Bn) IMF Volume ($ Bn)
Trends in Subordination (below AAA, A, BBB)30
Subprime
8
Alt-A
Subordination over Time
20
68
10
4
0 02
2001
q120
02q1
2003
q120
04q1
2005
q120
06q1
2007
q120
08q1
Year-Quarter
AAA Subordination AA/A Subordination
2001
q120
02q1
2003
q120
04q1
2005
q120
06q1
2007
q120
08q1
Year-Quarter
AAA Subordination AA/A Subordination
11for internal use only
BBB Subordination BBB Subordination
Hypotheses
Hypothesis 1: Ratings stability. Level of ratings remains constant through time after controlling for level ofconstant through time, after controlling for level of credit risk and structural features of the deal.
Hypothesis 2: Informational efficiency. Other credit risk variables do not systematically predict future deal y y p fperformance, after conditioning on ratings.
Benchmark: Ratings are an efficient forward‐looking summary statistic for credit risk; reflect all available information.
Analogy: Rational expectations forecasts (e.g. Sargent, 1987).
12for internal use only
Step 1: Default model
Baseline: simple logit model (10% LoanPerformance sample). Similar structure to Demyanyk & Van Hemert (2009).
Dependent variable: 90+ delinquent, REO, prepaid with loss after 12 months
Key predictors of default: Trailing house price appreciation (OFHEO, past 12 months), unemployment.
Underwriting : FICO score; debt‐to income (DTI); combined loan to valuation (CLTV) ratio; documentation of borrower income; investor dummy, SATO.
Loan type variables (ARM, FRM, interest only, balloon, refinancing, prepayment penalty dummy, loan size).
d l l h b Estimate model recursively every six months between 2001‐07.
Calculate expected default rate for each deal, based only on ex‐hi i l d (i d il bl i d l d)
13for internal use only
ante historical data (i.e. data available at time deal was rated).
Predicted and realized mortgage default rates
Fraction loans 90+ delinquent, prepaid with loss, REO 12 months after deal issuance
30
Subprime
10
Alt-A
20
5
100
2001
q1
2002
q1
2003
q1
2004
q1
2005
q1
2006
q1
2007
q1
2008
q1
Year-Quarter
Actual SD Forecast Model
0
2001
q1
2002
q1
2003
q1
2004
q1
2005
q1
2006
q1
2007
q1
2008
q1
Year-Quarter
Actual SD Forecast Model
14for internal use only
Determinants of AAA attachment pointDependent variable: ln(1+subordination below AAA class in percentage points)Dependent variable: ln(1+subordination below AAA class in percentage points).
Subprime Alt‐ACredit riskln(1+projected default rate) 0.751*** 0.680** 0.727*** 0.651***
(0.231) (0.254) (0.231) (0.186)(0.231) (0.254) (0.231) (0.186)ln(1+projected default rate)2 0.0551 0.0723 ‐0.130 ‐0.153**
(0.0676) (0.0705) (0.0870) (0.0707)Joint significance: F‐Test (p‐value) 0.0000*** 0.0000*** 0.0000*** 0.0006***Other deal characteristicsBond insurance (1=yes) ‐0.473*** ‐0.478*** ‐0.0250 0.00370
(0.100) (0.100) (0.0395) (0.0376)Fraction of deal with bond insurance ‐0.0104** ‐0.0104** ‐0.00331 ‐0.00414*
(0.00432) (0.00426) (0.00245) (0.00223)W i ht d t 0 00811 0 0201 0 0634*** 0 0231Weighted average coupon rate 0.00811 0.0201 ‐0.0634*** ‐0.0231
(0.0408) (0.0405) (0.0145) (0.0148)Weighted mortgage interest rate 0.0468* 0.0498** 0.0681* 0.0263
(0.0231) (0.0233) (0.0368) (0.0341)Geographic concentration of loans 1.897*** 1.677*** 0.406*** 0.399***Geographic concentration of loans 1.897 1.677 0.406 0.399
(0.212) (0.263) (0.134) (0.117)Year x quarter dummies Yes Yes Yes YesF‐test: ratings decline over 2005‐07? (p‐value)a 0.0001*** 0.0005*** 0.0054*** 0.759Include aggregated loan‐level variables No Yes No Yes
15for internal use only
Joint significance: F‐Test (p‐value) 0.144000 0.0000***N 1607 1607 1537 1537R2 0.529 0.531 0.193 0.281
Actual and predicted subordination15
2025
Subprime
2025
SubprimeDecomposition
05
10
1q1
1q3
2q1
2q3
3q1
3q3
4q1
4q3
5q1
5q3
6q1
6q3
7q1
7q3
510
15
2001
q20
01q
2002
q20
02q
2003
q20
03q
2004
q20
04q
2005
q20
05q
2006
q20
06q
2007
q20
07q
Year-Quarter, Deal Origination
95% Lower Bound 95% Upper Bound
Unconditional Subordination Linear Model
2004q4 2005q2 2005q4 2006q2 2006q4 2007q2Year-Quarter
Unconditional Subordination Model, All Char Fixed
Model, SD Forecast Fixed Model, HPA Fixed
67
8
Alt-A
67
8
Alt-A
34
5
2001
q120
01q3
2002
q120
02q3
2003
q120
03q3
2004
q120
04q3
2005
q120
05q3
2006
q120
06q3
2007
q120
07q3
45
6
16for internal use only
20 20 20 20 20 20 20 20 20 20 20 20 20 20
Year-Quarter, Deal Origination
95% Lower Bound 95% Upper Bound
Unconditional Subordination Linear Model
2004q4 2005q2 2005q4 2006q2 2006q4 2007q2Year-Quarter
Unconditional Subordination Model, All Char Fixed
Model, SD Forecast Fixed Model, HPA Fixed
Hypothesis 2: Informational efficiency
Relationship between ratings and ex‐post performance:
Performance = a. credit rating + b. credit enhancement
+ c. model‐projected default rate + ep j f
Null hypothesis: Projected credit risk and other variables do not systematically predict performance after conditioning on rating. (i.e. test c = 0, and also a 0).
f d b ( ) d f l ( ) d d Performance measured by: (i) defaults; (ii) rating downgrades; (iii) realized ex‐post losses.
17for internal use only
Ratings and ex‐post default: Subprime dealsA. SubprimeDependent variable: Fraction of deal in default 12 months after deal is issued
model, rating and
baselinerating only
model only
model & rating
rating and loan covariates
ln(1+% subordination below AAA) 0.285*** 0.112*** 0.112***( ) ( ) ( )(0.0396) (0.0340) (0.0305)
ln(1+% subordination below BBB‐) 0.110*** 0.0955*** 0.0645***(0.0211) (0.0157) (0.0144)
ln(1+projected default rate) 1 076*** 0 941*** 1 004***ln(1+projected default rate) 1.076 0.941 1.004(0.0566) (0.0622) (0.0567)
Other deal characteristics Yes Yes Yes Yes YesYear x quarter dummies Yes Yes Yes Yes YesLoan covariates aggregated to deal No No No No YesF‐test: Aggregated loan covariates [p‐val] 0.0000***
N 1607 1607 1607 1607 1607
18for internal use only
N 1607 1607 1607 1607 1607R2 0.092 0.275 0.483 0.521 0.862
Ratings and ex‐post default: Alt‐A dealsB. Alt‐ADependent variable: Fraction of deal in default 12 months after deal is issued
model, rating and
baselinerating only
model only
model & rating
rating and deal covariates
ln(1+% subordination below AAA) 0.356*** 0.198*** 0.0505(0.0531) (0.0378) (0.0344)
ln(1+% subordination below BBB‐) ‐0.201*** ‐0.144*** ‐0.0960***(0.0638) (0.0423) (0.0241)
ln(1+projected default rate) 1 556*** 1 470*** 1 523***ln(1+projected default rate) 1.556 1.470 1.523(0.0604) (0.102) (0.0422)
Other deal characteristics Yes Yes Yes Yes YesYear x quarter dummies Yes Yes Yes Yes YesAggregated mortgage characteristicsNo No No No YesF‐test: Deal‐lvl covariates [p‐value] 0.0000***
N 1537 1537 1537 1537 1537
19for internal use only
N 1537 1537 1537 1537 1537R2 0.330 0.394 0.618 0.640 0.893
Other determinants of default: Subprime (Alt‐A similar)Include projected default rate No Yes YesCredit boom interactions No No YesRating strategyOne Rating 0.509*** 0.213*** 0.305***
(0.126) (0.0343) (0.0392)Two Ratings 0 0475*** 0 0108 0 0505*Two Ratings ‐0.0475*** 0.0108 0.0505*
(0.0171) (0.0149) (0.0268)Four Ratings 0.0357 0.113*** 0.106***
(0.0274) (0.0290) (0.0275)Aggregate loan‐level covariates (FICO, IO not presented)gg g ( p )LTV 0.000992 0.00889*** 0.00715***
(0.00350) (0.00188) (0.00169)HPA ‐0.0184** ‐0.00279 ‐0.00245
(0.00745) (0.00815) (0.00753)L d 0 00725*** 0 00681*** 0 00327***Low doc 0.00725*** 0.00681*** 0.00327***
(0.000873) (0.000656) (0.000852)Investor 0.00756** 0.00430* 0.0212***
(0.00334) (0.00230) (0.00454)Loan level covariate interactionsProjected delinquency rate * boom 0.317***
(0.0939)Low doc * boom 0.00568***
(0.00115)I * b 0 0216***
20for internal use only
Investor * boom ‐0.0216***(0.00507)
Less Than Three Ratings* boom ‐0.0667**(0.0295)
Vintage analysis: Subprime deals (Alt‐A estimates similar)Vintage All
Years2001 2002 2003 2004 2005 2006 2007A. Subprime dealsBaseline (just deal controls; same as Column 1 of Table 6)R2 0 341 0 409 0 309 0 195 0 026 0 402 0 260 0 092R2 0.341 0.409 0.309 0.195 0.026 0.402 0.260 0.092Baseline & ratingSubordination below AAA 0.343** 0.0852 0.104 0.236*** 0.369** 0.512** 0.474*** 0.285***
(0.0606) (0.0503) (0.0884) (0.0216) (0.0913) (0.137) (0.0634) (0.0393)Subordination below BBB‐ ‐0.260 ‐0.0221 0.178** 0.0405 0.0448 ‐0.0294 0.0403 0.110***
(0.314) (0.184) (0.0530) (0.0264) (0.0269) (0.0494) (0.0673) (0.0209)R2 0.520 0.424 0.359 0.365 0.154 0.487 0.559 0.275Baseline & model predictionProjected delinquency rate 1.072*** 0.864*** 0.718*** 0.927*** 1.428*** 0.825** 1.224*** 1.076***
(0 0249) (0 113) (0 106) (0 129) (0 0202) (0 228) (0 0252) (0 0561)(0.0249) (0.113) (0.106) (0.129) (0.0202) (0.228) (0.0252) (0.0561)R2 0.856 0.716 0.516 0.413 0.449 0.550 0.674 0.483Baseline & rating & model predictionSubordination below AAA 0.00254 ‐0.0372 0.0423 0.146** 0.116 0.331* 0.196* 0.112***
(0.0817) (0.0526) (0.0875) (0.0390) (0.0561) (0.136) (0.0767) (0.0337)( ) ( ) ( ) ( ) ( ) ( ) ( ) ( )Subordination below BBB‐ 0.0312 ‐0.00253 0.165** 0.0662** 0.0561 ‐0.0191 0.0427 0.0955***
(0.0288) (0.101) (0.0471) (0.0143) (0.0286) (0.0347) (0.0647) (0.0156)Projected delinquency rate 1.070*** 0.889*** 0.684*** 0.753*** 1.327*** 0.697* 0.942*** 0.941***
(0.106) (0.146) (0.109) (0.127) (0.0340) (0.275) (0.0275) (0.0617)R2 0 856 0 719 0 537 0 490 0 471 0 582 0 713 0 521
21for internal use only
R2 0.856 0.719 0.537 0.490 0.471 0.582 0.713 0.521
N 63 90 166 286 370 422 210 1607
Determinants of rating downgrades
Subprime Alt‐A
Deal subordination below AAA ‐0.923*** ‐0.902*** ‐0.0465 ‐0.566*
(0.246) (0.258) (0.227) (0.282)
Deal subordination below BBB‐ 0.630*** 0.442** 1.489*** 1.640***
(0.206) (0.178) (0.420) (0.440)(0.206) (0.178) (0.420) (0.440)
Projected default rate 0.817* 0.748 2.595*** 3.066***
(0.472) (0.597) (0.909) (0.948)
Other deal characteristics Yes Yes Yes Yes
Rating strategy No Yes No Yes
Aggregated loan covariates No Yes No YesAggregated loan covariates No Yes No Yes
Year x quarter dummies Yes Yes Yes Yes
N 1607 1607 1537 1537
22for internal use only
R2 0.612 0.654 0.674 0.685
Determinants of realized losses to dateA. Dependent variable: Realized losses to date
Subprime Alt‐A
model, rating and
model, rating and
rating onlymodel onlymodel & rating
deal covariates
rating only
model only
model & rating
deal covariates
ln(1+subn. below AAA) 0.0468* 0.0337 0.0397 0.389*** 0.290*** 0.0689
(0 0264) (0 0328) (0 0263) (0 0676) (0 0672) (0 0502)(0.0264) (0.0328) (0.0263) (0.0676) (0.0672) (0.0502)
ln(1+subn. below BBB) 0.164*** 0.163*** 0.124*** ‐0.129** ‐0.0971** ‐0.0402**
(0.0260) (0.0258) (0.0191) (0.0503) (0.0374) (0.0189)
j d d f l 0 1 *** 0 06 0 369*** 0 9 2*** 0 8 1*** 0 68 ***Projected default rate 0.157*** 0.0677 0.369*** 0.972*** 0.841*** 0.684***
(0.0546) (0.0728) (0.0668) (0.139) (0.145) (0.0726)
Other deal characteristics Yes Yes Yes Yes Yes Yes Yes Yes
Year x quarter dummies Yes Yes Yes Yes Yes Yes Yes YesqDeal‐level mortgage characteristics No No No Yes No No No YesF‐test: Deal‐level covariates [p‐value] 0.0000*** 0.0000***
23for internal use only
N 1567 1567 1567 1567 1461 1461 1461 1461
R2 0.389 0.361 0.390 0.516 0.297 0.344 0.383 0.611
Remarks
Low doc deals particularly underperform their rating.
Consistent with theoretical work that opacity is related toConsistent with theoretical work that opacity is related to degree of rating bias (Skreta and Veldkamp, JME, 2009).
Also consistent with Rajan, Seru and Vig (2009). j g
In several dimensions, our results are stronger for Alt‐A deals than subprime deals. Overall downgrades also greater for Alt‐A.
Robustness checks:
Alternative measures of performance: (i) default at 24 months; (ii) default to date.
More complex default models (interactions between different d i i i bl )
24for internal use only
underwriting variables etc.).
Summary
Time variation in rating standards; erosion between 2005‐07. (Deals become riskier, but ratings stay flat.)
Ratings are informative, but surprisingly less predictive of ex‐post performance than “naïve” summary statistic.
High‐risk deals as measured by summary statistic, perform significantly worse ex‐post (defaults, downgrades, losses).
Particularly true for Alt A deals low doc deals Particularly true for Alt‐A deals, low doc deals.
True over whole sample, not just during the crisis.
C Al h h i id l Caveat: Although some suggestive evidence, our results are not conclusive as to whether observed limitations in ratings reflect agency problems, or “innocent” shortcomings in methodology.
25for internal use only
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