| dc.description.abstract | This paper values Mortgage Backed Securities (MBS) in an equilibrium framework that explicitly incorporates the default decisions of homeowners and essential contractual features of MBS. We first consider Collateralized Mortgage Obligations (CMOs), securities created by dividing a pool of mortgages into senior and residual tranches. We find that senior CMO bonds can be risk-free, low-risk or high-risk in equilibrium, depending on the relative size of the senior tranche. We extend the basic framework to value CMO-squared, securities created by pooling residual CMO bonds and dividing the pool into tranches. We find that senior CMO-squared bonds are riskier than senior CMO bonds of the same size, when CMO-squared are created using residual CMO bonds. Finally, we value Credit Default Swaps (CDSs), securities that provide insurance against default. For house price data from the Case-Shiller index between 2006 and 2011, we find that senior CMO bond prices decline by 10% and residual bond prices decline by 60%. The price declines experienced by CMO-squared bonds are larger: senior bond prices drop 50% and residual bond prices drop 100%. The quantitative exercises suggest that default risk is an important factor for valuation of CDS written on residual CMO bonds, but not for CDS written on senior CMO bonds. | en_GB |
