The predictive strength of MBS yield spreads during asset bubbles

Abstract

We examine whether the predictive power of initial yield spreads of mortgage-backed securities (MBS) vary with the financial cycle. Using a crosscountry sample of 4203 MBS, we find that initial yield spreads of MBS incorporate more information than credit ratings and predict future downgrades, even after conditioning on initial credit ratings. Predictive power of spreads is higher during credit and housing bubbles and for the least risky AAArated MBS. We find that initial yield spreads capture the magnitude of rating downgrades, especially during asset bubble periods. As a novel approach in this literature, we also utilise machine learning techniques (regression trees, naïve Bayes, support vector machines and random forests) to confirm our results.

Do investors value frequent issuers in securitization?

“…More interestingly,Deku et al (2020) find that the predictive power of launch spreads is much higher during credit booms. Thus, the reliance on reputation may have enabled certain investors to minimise the losses they would have incurred otherwise.…”