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The Bear's Lair: Index Credit Default Swaps and the Subprime Mortgage Crisis

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  • Richard Stanton
  • Nancy Wallace

Abstract

During the recent financial crisis, ABX.HE index credit default swaps (CDS) on baskets of mortgage-backed securities were a benchmark widely used by financial institutions to mark their subprime mortgage portfolios to market. However, we find that prices for the AAA ABX.HE index CDS during the crisis were inconsistent with any reasonable assumption for mortgage default rates, and that these price changes are only weakly correlated with observed changes in the credit performance of the underlying loans in the index, casting serious doubt on the suitability of these CDS as valuation benchmarks. We also find that the AAA ABX.HE index CDS price changes are related to short-sale activity for publicly traded investment banks with significant mortgage market exposure. This suggests that capital constraints, limiting the supply of mortgage-bond insurance, may be playing a role here similar to that identified by Froot (2001) in the market for catastrophe insurance. The Author 2011. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oup.com., Oxford University Press.

Suggested Citation

  • Richard Stanton & Nancy Wallace, 2011. "The Bear's Lair: Index Credit Default Swaps and the Subprime Mortgage Crisis," The Review of Financial Studies, Society for Financial Studies, vol. 24(10), pages 3250-3280.
    • Handle: RePEc:oup:rfinst:v:24:y:2011:i:10:p:3250-3280
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    Cited by:

    1. Kolasinski, Adam C. & Yang, Nan, 2018. "Managerial myopia and the mortgage meltdown," Journal of Financial Economics, Elsevier, vol. 128(3), pages 466-485.
    2. Augustin, Patrick & Subrahmanyam, Marti G. & Tang, Dragon Yongjun & Wang, Sarah Qian, 2014. "Credit Default Swaps: A Survey," Foundations and Trends(R) in Finance, now publishers, vol. 9(1-2), pages 1-196, December.
    3. Wang, Xinjie & Zhong, Zhaodong (Ken), 2022. "Dealer inventory, pricing, and liquidity in the OTC derivatives markets: Evidence from index CDSs," Journal of Financial Markets, Elsevier, vol. 57(C).
    4. Uhlig, Harald & Ospina, Juan, 2018. "Mortgage-Backed Securities and the Financial Crisis of 2008: a Post Mortem," CEPR Discussion Papers 12852, C.E.P.R. Discussion Papers.
    5. Lahiani, Amine & Hammoudeh, Shawkat & Gupta, Rangan, 2016. "Linkages between financial sector CDS spreads and macroeconomic influence in a nonlinear setting," International Review of Economics & Finance, Elsevier, vol. 43(C), pages 443-456.
    6. Jansson, Walter, 2021. "Revisiting Subprime Pricing Irrationality During the Global Financial Crisis," Journal of Financial Crises, Yale Program on Financial Stability (YPFS), vol. 3(2), pages 1-40, April.
    7. Marcel Nutz & José A. Scheinkman, 2020. "Shorting in Speculative Markets," Journal of Finance, American Finance Association, vol. 75(2), pages 995-1036, April.
    8. Efthymios G. Tsionas, 2014. "On modeling banking risk," Working Papers 183, Bank of Greece.
    9. Flavin, Thomas J. & Sheenan, Lisa, 2015. "The role of U.S. subprime mortgage-backed assets in propagating the crisis: Contagion or interdependence?," The North American Journal of Economics and Finance, Elsevier, vol. 34(C), pages 167-186.
    10. Andrey Pavlov & Eduardo Schwartz & Susan Wachter, 2021. "Price Discovery Limits in the Credit Default Swap Market in the Financial Crisis," The Journal of Real Estate Finance and Economics, Springer, vol. 62(2), pages 165-186, February.
    11. Beltratti, Andrea & Spear, Nasser & Szabo, Mark Daniel, 2013. "The Value Relevance and Timeliness of Write-downs During the Financial Crisis of 2007–2009," The International Journal of Accounting, Elsevier, vol. 48(4), pages 467-494.
    12. Warren Bailey & Lin Zheng & Yinggang Zhou, 2012. "What Makes the VIX Tick?," Working Papers 222012, Hong Kong Institute for Monetary Research.
    13. Susan M. Wachter, 2018. "Credit risk transfer, informed markets, and securitization," Economic Policy Review, Federal Reserve Bank of New York, issue 24-3, pages 117-137.
    14. Tsionas, Mike G., 2016. "Parameters measuring bank risk and their estimation," European Journal of Operational Research, Elsevier, vol. 250(1), pages 291-304.
    15. Christopoulos, Andreas D. & Jarrow, Robert A., 2018. "CMBS market efficiency: The crisis and the recovery," Journal of Financial Stability, Elsevier, vol. 36(C), pages 159-186.
    16. Bhanot, Karan & Larsson, Carl F., 2018. "Uncovering the impact of regulatory uncertainty on credit spreads: A study of the U.S. covered bond experience," Journal of Financial Markets, Elsevier, vol. 39(C), pages 84-110.
    17. Beatty, Anne & Liao, Scott, 2014. "Financial accounting in the banking industry: A review of the empirical literature," Journal of Accounting and Economics, Elsevier, vol. 58(2), pages 339-383.
    18. Kruger, Samuel, 2018. "The effect of mortgage securitization on foreclosure and modification," Journal of Financial Economics, Elsevier, vol. 129(3), pages 586-607.
    19. José Jorge, 2016. "Sovereign Ratings and Investor Behavior," CEF.UP Working Papers 1601, Universidade do Porto, Faculdade de Economia do Porto.
    20. Rossen Valkanov & Andra Ghent, 2014. "Complexity in Structured Finance: Financial Wizardry or Smoke and Mirrors," 2014 Meeting Papers 104, Society for Economic Dynamics.
    21. Adam J. Levitin & Desen Lin & Susan M. Wachter, 2020. "Mortgage Risk Premiums during the Housing Bubble," The Journal of Real Estate Finance and Economics, Springer, vol. 60(4), pages 421-468, May.
    22. Wojtowicz, Marcin, 2014. "CDOs and the financial crisis: Credit ratings and fair premia," Journal of Banking & Finance, Elsevier, vol. 39(C), pages 1-13.
    23. Aragon, George O. & Li, Lei & Qian, Jun ‘QJ’, 2019. "The use of credit default swaps by bond mutual funds: Liquidity provision and counterparty risk," Journal of Financial Economics, Elsevier, vol. 131(1), pages 168-185.
    24. Driessen, Joost & Van Hemert, Otto, 2012. "Pricing of commercial real estate securities during the 2007–2009 financial crisis," Journal of Financial Economics, Elsevier, vol. 105(1), pages 37-61.

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