The Design of Subprime Mortgage-backed Securities and Information Insensitivity

Abstract

What is the securitization process for? What exactly happened in the subprime mortgage-backed securities (MBSs) market from the housing boom to the global financial crisis? To answer these questions, I use a novel hand-collected dataset of subprime MBSs issued between 2004 and 2007, which includes a detailed description of underlying mortgage characteristics and deal structures. This paper studies the purpose of the securitization process in the context of the subprime MBS market as a trigger of the global financial crisis. I find that the credit enhancements reflect the credit risks of underlying collaterals, thus ex-ante qualities of AAA subprime MBS tranches had not been deteriorated. In addition, the AAA tranche spreads are mostly explained by the bond market conditions and uncorrelated with the credit risk of collateral. This results suggest that market participants designed and priced the subprime MBSs in the way that the AAA tranche could be information insensitive. In other words, the securitization process makes it possible that market participants have less incentive to learn about the underlying collateral information.