Working Paper #632
The Subprime Mortgage Market and the Valuation of Subprime Bonds
William R. Greenberg · Brook S. Payner
This paper describes the current state of the subprime mortgage market and provides an historical context for the market dynamics that led to the present environment. The authors introduce a model to estimate the market’s expectations of future losses on pools of subprime mortgages, using the market prices of the ABX indices. The model shows that the market is expecting roughly 30 percent losses on 2007 originated loans, 20 percent to 25 percent on 2006 originated loans, and around 15 percent on 2005 vintage loans. At these levels of losses, most BBB-rated securities are wiped out in all vintages, and the securities should be valued as interest-only (IO) values (no return of principal). Many newer A-rated and AA-rated bonds are also expected to take losses. Nevertheless, even though correlations amongst security performance are high, there is some dispersion, and pockets of better-performing bonds do exist, which can have impact on the valuations of super-senior CDO tranches.