Essays on Structured Finance and Housing Markets
The fall in housing market prices has played a major role in triggering the Great Recession. This led to the collapse of markets for mortgage-backed securities, and to a precipitous fall in their ratings. This thesis studies the downgrading of mortgaged-backed Collateralized Debt Obligation (CDO), and the factors that drive mortgage default loans. In Chapter 1, I look at the CDO market. The downgrading of the tranches of Collateralized Debt Obligation (CDO) products backed by real estate related assets has caused severe disruptions in the housing and financial markets. The rating agencies have been criticized for the opacity in the rating process of the CDO products and also for giving the CDO tranches higher ratings than they deserved. However, not enough attention has been paid to the decision making process of the agencies to downgrade the CDO tranches. We use data from Moody's CDO database to reconstruct the process through which Moody's eventually downgraded the tranches. We use a discrete hazard rate model to study the variables that were relevant in the downgrading of the tranches of the CDOs. The empirical results show that out of the many CDO specific variables relevant to their ratings made available by Moody's few have any explanatory power beyond the Moody's Deal Scores (MDS). We show that the MDS could be explained by the changes in the Case-Shiller Composite-20 Index and Markit ABX.HE indices. Further analysis shows that Moody's mostly relied on the changes in the Case-Shiller indexes in revising the MDS. In Chapter 2 I look at the factors that influence default rates. The chapter uses a Structural Vector Autoregression (SVAR) model to study the dynamics of the impact of unemployment and home price index shocks on mortgage default rates from 1979 to 2000 and from 2001 to 2010. We first fit the model to the 1979 to 2000 sample and forecast the changes in the national and regional mortgage default rates from 2001 to 2010. The model did a good job in forecasting the actual changes in the mortgage default rates from 2001 to 2007; however, it failed after 2008. The results for the 1979 to 2000 and 2001 to 2010 periods indicate that the dynamic response of the mortgage default rate to unemployment and home price index shocks changed at the national, regional and state levels after 2000. Unemployment and home price shocks seem to have become more important during the 2001 to 2010 period. The two shocks are responsible on average for about 60% of the movement in the regional mortgage default rates during this period. Except for the Pacific region, California and Florida, most of the variations in the mortgage default rates at the national, regional and state levels are explained by the unemployment shocks. The post 2000 results could be attributed to the increase in the number of mortgage loan borrowers who were more susceptible to unemployment and negative home price shocks.
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