Systematic and Liquidity Risk in Subprime-Mortgage Backed Securities

Mardi Dungey, Gerald P. Dwyer, and Thomas Flavin
Working Paper 2011-15
November 2011

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The misevaluation of risk in securitized financial products is central to understanding the financial crisis of 2007–8. This paper characterizes the evolution of factors affecting collateralized debt obligations based on subprime mortgages. A key feature of subprime-mortgage backed indices is that they are distinct in their vintage of issuance. Using a latent factor framework that incorporates this vintage effect, we show the increasing importance of a common factor on more senior tranches during the crisis. We examine this common factor and its relationship with spreads. We estimate the effects on the common factor of the financial crisis.

JEL classification: G12, G01, C32

Key words: asset-backed securities, subprime mortgages, financial crisis, factor models, Kalman filter

We are grateful for comments from Paul Koch, Belén Nieto, Ellis Tallman, participants at the INFINITI 2010 conference, the Western Economic Association 2010 conference, the Financial Management Association 2009 conference, and the Federal Reserve "Day Ahead" conference on Financial Markets in 2009. We thank Christian Gilles, Paul Kupiec, and Charles Smithson for important assistance in understanding the ABX index of CDO prices. Dungey acknowledges support from ARC Discovery Grant DP0664024. Dwyer thanks the Spanish Ministry of Education and Culture for support of project SEJ2007-67448/ECON and ECO2010-17158. The views expressed here are the authors' and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors' responsibility.

Please address questions regarding content to Mardi Dungey, University of Tasmania and CFAP, University of Cambridge, School of Economics and Finance, University of Tasmania, Private Bag 85, Hobart, Tasmania 7001, Australia, 61 3 6226 7672,; Gerald P. Dwyer, Federal Reserve Bank of Atlanta and University of Carlos III, Madrid, Research Department, 1000 Peachtree Street, N.E., Atlanta, Georgia 30309-4470, 404-498-7095,; or Thomas Flavin, Department of Economics, Finance & Accounting, National University of Ireland, Maynooth, Maynooth, Kildare, Ireland, 353 1 7083369,

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