【Speaker】Harold H. Zhang, Professor of Finance, University of Texas at Dallas

【Topic】Subprime Mortgage Defaults and Credit Default Swaps

【Time】13:30-15:30, 2010-06-03

【Venue】Room 201, Shunde Building, Tsinghua SEM

【Language】English

【Organizer】Department of Finance, Department of Economics, Department of Accounting

Abstract

We examine the effect of the dramatic growth in credit default swaps (CDS) on subprime mortgage defaults, which is at the center of the recent financial crisis. In a simple model, we show that the introduction of CDS encourages loans to high risk borrowers by shifting default risk from mortgage lenders to CDS sellers. With uncertainty and ambiguity about high risk borrowers’ default probabilities, CDS sellers charge premiums on CDS contracts to reflect worst-case default probabilities. This leads to above normal loan rates to risky borrowers, which drives higher default probabilities on high risk loans. Using a comprehensive dataset of mortgage loans originated between 2001 and 2007, consistent with our model we document that pools of subprime loans insured with CDS contracts experience significantly larger default rates than pools of subprime loans that are not insured with CDS contracts, after controlling for an extensive set of variables known to affect default. Our findings suggest that the dramatic growth of the CDS market contributed to higher subprime mortgage defaults.