MBS ratings and the mortgage credit boom - unibocconi.it · MBS ratings and the mortgage credit boom Adam Ashcraft ... standards at end of mortgage credit boom ... FICO score; debt‐to

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?


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/ /


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


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);


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


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


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


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)


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


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).


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)


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


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


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


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.


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


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


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***


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


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


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***


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 )


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.


Documents

MBS ratings and the mortgage credit boom - unibocconi.it · MBS ratings and the mortgage credit boom Adam Ashcraft ... standards at end of mortgage credit boom ... FICO score; debt‐to