Did prepayments sustain the subprime market?

This paper demonstrates that the reason for widespread default of mortgages in the subprime market was a sudden reversal in the house price appreciation of the early 2000's. Using loan-level data on subprime mortgages, we observe that the majority of subprime loans were hybrid adjustable rate mortgages, designed to impose substantial financial burden on reset to the fully indexed rate. In a regime of rising house prices, a financially distressed borrower could avoid default by prepaying the loan and our results indicate that subprime mortgages originated between 1998 and 2005 had extremely high prepayment rates. However, a sudden reversal in house price appreciation increased default in this market because it made this prepayment exit option cost-prohibitive.Subprime mortgage

Credit scoring and loan default

This paper introduces a measure of credit score performance that abstracts from the influence of “situational factors.” Using this measure, we study the role and effectiveness of credit scoring that underlied subprime securities during the mortgage boom of 2000-2006. Parametric and nonparametric measures of credit score performance reveal different trends, especially on originations with low credit scores. The paper demonstrates an increasing trend of reliance on credit scoring not only as a measure of credit risk but also as a means to offset other riskier attributes of the origination. This reliance led to deterioration in loan performance even though average credit quality—as measured in terms of credit scores— actually improved over the years.Credit scoring systems ; Mortgage loans

A Simulation Based Specification Test for Diffusion Processes

This paper makes two contributions. First, we outline a simple simulation based framework for constructing conditional distributions for multi-factor and multi-dimensional diffusion processes, for the case where the functional form of the conditional density is unknown. The distributions can be used, for example, to form predictive confidence intervals for time period t + τ, given information up to period t. Second, we use the simulation based approach to construct a test for the correct specification of a diffusion process. The suggested test is in the spirit of the conditional Kolmogorov test of Andrews (1997). However, in the present context the null conditional distribution is unknown and is replaced by its simulated counterpart. The limiting distribution of the test statistic is not nuisance parameter free. In light of this, asymptotically valid critical values are obtained via appropriate use of the block bootstrap. The suggested test has power against a larger class of alternatives than tests that are constructed using marginal distributions/densities, such as those in Aït-Sahalia (1996) and Corradi and Swanson (2005a). The findings of a small Monte Carlo experiment underscore the good finite sample properties of the proposed test, and an empirical illustration underscores the ease with which the proposed simulation and testing methodology can be applied

Fooling Some of the People All of the Time: The Inefficient Performance and Persistence of Commodity Trading Advisors

Investors face significant barriers in evaluating the performance of hedge funds and commodity trading advisors (CTAs). The only available performance data comes from voluntary reporting to private companies. Funds have incentives to strategically report to these companies, causing these data sets to be severely biased. And, because hedge funds use nonlinear, state-dependent, leveraged strategies, it has proven difficult to determine whether they add value relative to benchmarks. We focus on commodity trading advisors, a subset of hedge funds, and show that during the period 1994-2007 CTA excess returns to investors (i.e., net of fees) averaged 85 basis points per annum over US T-bills, which is insignificantly different from zero. We estimate that CTAs on average earned gross excess returns (i.e., before fees) of 5.4%, which implies that funds captured most of their performance through charging fees. Yet, even before fees we find that CTAs display no alpha relative to simple futures strategies that are in the public domain. We argue that CTAs appear to persist as an asset class despite their poor performance, because they face no market discipline based on credible information. Our evidence suggests that investors' experience of poor performance is not common knowledge.

Tradable Permits for Environmental Protection: Case Study of an Integrated Steel Plant in India

Cost effective policies allow minimising the compliance costs associated to reaching a desired environmental quality target. In this paper a conceptual model has been developed to examine the compliance costs under an intra-plant emission trading system for a non-uniformly mixed assimilative pollutant. The model incorporates the number of emission sources, the concentration of pollutants emitted at each source, the marginal cost of abatement for each source, the transfer coefficient that relates emission at each source with the impact on ambient air quality, and the desired ambient air quality target. The model is applied to an integrated steel plant in India. Results of this study demonstrate that the emission trading is more cost effective than the existing regulatory system. Further, intra-plant trades would result in significant savings to the steel plant while securing an improvement in ambient air quality in the studied geographical area.tradable permits, carbon trading, pollution abatement, emission, intra-plant trades, ambient air quality, integrated steel plant, India, Economics, Environment Studies,