Second Mortgages: Valuation and Implications for the Performance of Structured Financial Products

Kristian R. Miltersen, Walter N. Torous

Research output: Contribution to conferencePaperResearchpeer-review

Abstract

Many homeowners cash-out refinanced in concert to extract equity from their properties during the run-up in U.S. house prices. We demonstrate that the risk characteristics of first-lien mortgages are systematically altered when second mortgages are behind them. Cash-out refinancing also effectively correlates homeowners' default decisions so that a large drop in house prices can result in almost all of these homeowners defaulting together. In this case, even the most senior tranches of structured financial products collateralized by first-lien mortgages may no longer be protected from default losses. When a collateralized debt obligation (CDO) structured under the assumption that homeowners cannot cash-out
refinance is subsequently confronted by data generated by homeowners with \secret" seconds, the CDO's resultant performance is broadly consistent with the magnitude of CDO downgrades observed after the bursting of the U.S. housing bubble. By contrast, our results are not consistent with the argument that the observed downgrades occurred because the severity of the U.S. housing market downturn was underestimated by credit rating agencies.
Original languageEnglish
Publication date2014
Number of pages43
Publication statusPublished - 2014
EventThe 49th AREUEA-ASSA Conference 2014 - Philadelphia, PA, United States
Duration: 3 Jan 20145 Jan 2014
Conference number: 49
https://www.areuea.org/conferences/details.phtml?id=95

Conference

ConferenceThe 49th AREUEA-ASSA Conference 2014
Number49
CountryUnited States
CityPhiladelphia, PA
Period03/01/201405/01/2014
OtherIncl. joint sessions with the American Economic Association (AEA) and with the American Finance Association (AFA)
Internet address

Cite this

Miltersen, K. R., & Torous, W. N. (2014). Second Mortgages: Valuation and Implications for the Performance of Structured Financial Products. Paper presented at The 49th AREUEA-ASSA Conference 2014, Philadelphia, PA, United States.
Miltersen, Kristian R. ; Torous, Walter N. / Second Mortgages : Valuation and Implications for the Performance of Structured Financial Products. Paper presented at The 49th AREUEA-ASSA Conference 2014, Philadelphia, PA, United States.43 p.
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Miltersen, KR & Torous, WN 2014, 'Second Mortgages: Valuation and Implications for the Performance of Structured Financial Products' Paper presented at, Philadelphia, PA, United States, 03/01/2014 - 05/01/2014, .

Second Mortgages : Valuation and Implications for the Performance of Structured Financial Products. / Miltersen, Kristian R.; Torous, Walter N.

2014. Paper presented at The 49th AREUEA-ASSA Conference 2014, Philadelphia, PA, United States.

Research output: Contribution to conferencePaperResearchpeer-review

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T2 - Valuation and Implications for the Performance of Structured Financial Products

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PY - 2014

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N2 - Many homeowners cash-out refinanced in concert to extract equity from their properties during the run-up in U.S. house prices. We demonstrate that the risk characteristics of first-lien mortgages are systematically altered when second mortgages are behind them. Cash-out refinancing also effectively correlates homeowners' default decisions so that a large drop in house prices can result in almost all of these homeowners defaulting together. In this case, even the most senior tranches of structured financial products collateralized by first-lien mortgages may no longer be protected from default losses. When a collateralized debt obligation (CDO) structured under the assumption that homeowners cannot cash-outrefinance is subsequently confronted by data generated by homeowners with \secret" seconds, the CDO's resultant performance is broadly consistent with the magnitude of CDO downgrades observed after the bursting of the U.S. housing bubble. By contrast, our results are not consistent with the argument that the observed downgrades occurred because the severity of the U.S. housing market downturn was underestimated by credit rating agencies.

AB - Many homeowners cash-out refinanced in concert to extract equity from their properties during the run-up in U.S. house prices. We demonstrate that the risk characteristics of first-lien mortgages are systematically altered when second mortgages are behind them. Cash-out refinancing also effectively correlates homeowners' default decisions so that a large drop in house prices can result in almost all of these homeowners defaulting together. In this case, even the most senior tranches of structured financial products collateralized by first-lien mortgages may no longer be protected from default losses. When a collateralized debt obligation (CDO) structured under the assumption that homeowners cannot cash-outrefinance is subsequently confronted by data generated by homeowners with \secret" seconds, the CDO's resultant performance is broadly consistent with the magnitude of CDO downgrades observed after the bursting of the U.S. housing bubble. By contrast, our results are not consistent with the argument that the observed downgrades occurred because the severity of the U.S. housing market downturn was underestimated by credit rating agencies.

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Miltersen KR, Torous WN. Second Mortgages: Valuation and Implications for the Performance of Structured Financial Products. 2014. Paper presented at The 49th AREUEA-ASSA Conference 2014, Philadelphia, PA, United States.