Events

Finance Seminar

Authors:

• David Mauer
  University of Texas at Dallas

• Eric Arentsen
  TCW Group

• Brian Rosenlund
  TCW Group

• Harold Zhang
  the University of Texa

• Feng Zhao
  the University of Texa

This paper offers the first empirical investigation of the influence of credit default swaps (CDS) on subprime mortgage defaults during the financial crisis. We argue that since issuers and investors in mortgage-backed securities (MBS) could hedge the credit risk of the subprime loans underlying MBS with CDS contracts, this helped fuel the demand for subprime loans, which were supplied by loan originators who reduced lending standards to meet demand. Using a database that contains more than 90% of the privately securitized subprime mortgages originated during the period from 2003 to 2007, we identify which loans were in MBS deals protected by CDS contracts. Controlling for borrower and loan characteristics, MBS issuer types, and regional housing and economic conditions, we find that CDS coverage significantly increased the probability of loan delinquency. Our estimates suggest that CDS contracts increased the dollar value of delinquent subprime loans by $9.9 billion to $13.3 billion during the financial crisis.