33 Pages Posted: 14 Oct 2008
Date Written: October 7, 2008
As the fallout from subprime losses clearly demonstrates, the credit risk in residential mortgages is large and economically significant. To manage this risk, this paper proposes the creation of derivative instruments based on the credit losses of a reference mortgage pool. We argue that these derivatives would enable banks to retain whole loans while also enjoying the capital benefits of hedging the credit risk in their mortgage portfolios. In comparisons of hedging effectiveness, we show that instruments based on credit losses outperform contracts based on house-price appreciation.
Keywords: Credit risk, residential mortgages, credit derivatives
JEL Classification: G21
Suggested Citation: Suggested Citation