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Applied Economics Letters

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A note on the subprime mortgage crisis: dynamic

modelling of bank leverage profit under loan
securitization
a a a
Mark Adam Petersen , Mmboniseni Phanuel Mulaudzi , Janine Mukuddem-Petersen & Ilse
a
Schoeman
a
Department of Mathematics and Applied Mathematics , North-West University
(Potchefstroom Campus) , Private Bag X 6001, Potchefstroom, 2520, South Africa
Published online: 10 Nov 2009.

To cite this article: Mark Adam Petersen , Mmboniseni Phanuel Mulaudzi , Janine Mukuddem-Petersen & Ilse Schoeman
(2010) A note on the subprime mortgage crisis: dynamic modelling of bank leverage profit under loan securitization, Applied
Economics Letters, 17:15, 1469-1474, DOI: 10.1080/13504850903035907

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 Applied Economics Letters, 2010, 17, 1469–1474

A note on the subprime mortgage

crisis: dynamic modelling of bank
leverage profit under loan
securitization
Mark Adam Petersen*, Mmboniseni Phanuel Mulaudzi,
Janine Mukuddem-Petersen and Ilse Schoeman
Department of Mathematics and Applied Mathematics, North-West
University (Potchefstroom Campus), Private Bag X 6001, Potchefstroom
Downloaded by [Columbia University] at 19:41 14 November 2014

2520, South Africa

In this brief research article, we consider the financial modelling of the

process of mortgage loan securitization that has been a root cause of the
ongoing Subprime Mortgage Crisis (SMC). In particular, we suggest a
Levy process-driven model of bank leverage profit that arises from the
securitization of a pool of subprime mortgage loans. To achieve this, we
develop stochastic models for mortgage loans, mortgage loan losses,
credit ratings and mortgage loan guarantees in a subprime context.
These models incorporate some of the most important issues related to
the SMC and its causes. Finally, we provide a brief analysis of the
models developed earlier in our contribution and its relationship with
the SMC.

I. Introduction Step 1: The bank lends money to mortgagors.

To understand the current Subprime Mortgage Crisis
(SMC), a deeper investigation of bank profitability
under asset securitization is required. The latter entails
the pooling of assets, usually with similar cash flow
characteristics and issuance of securities whose pay-
ments are derived from the underlying pool cash flow.
Financial institutions use securitization to realize the
value of cash-producing assets such as mortgage
loans, credit card loans, traded receivables and study
fees. From being virtually nonexistent 40 years ago,
the US securitization industry had grown to be worth
an estimated $6.6 trillion by the end of 2004. Our
particular focus is on the securitization of subprime
mortgage loans into Mortgage-Backed Securities
(MBSs) by the steps below (see Fig. 1 for a diagram-
matic overview).
Step 2: The bank creates a mortgage pool from a
group of similar mortgages and sells the MBSs to
the investors.
Step 3: The mortgagors pay periodic payments to
the bank.
Step 4: The bank collects mortgage payments,
extracts servicing fees, pays mortgage loan guaran-
tee fees to the guarantor and pays the interest rate
charged by investors.
Step 5: When the mortgagor defaults, the guarantor
covers the (secondary) mortgage loan losses faced
by investors.
A diagrammatic overview of the mortgage loan
securitization suggested above is represented in Fig. 1.
From Fig. 1, we have that 1a is the rate of cash
flow, I, from investors to the financial institution

*Corresponding author. E-mail: Mark.Petersen@nwu.ac.za

Applied Economics Letters ISSN 1350–4851 print/ISSN 1466–4291 online  2010 Taylor & Francis 1469
http://www.informaworld.com
DOI: 10.1080/13504850903035907
 1470
Fig. 1. Diagrammatic overview of mortgage loan securitization
Downloaded by [Columbia University] at 19:41 14 November 2014
(which in our case we consider to be a bank) for the
express purpose of securitizing the portfolio of
mortgage loans. In addition, 1b represents the inter-
est rate, rI, paid to investors while 1c is the rate of
cash flow, k, from the bank for financing the MBSs
portfolio. The cash flow 1d is the interest rate
received from the MBSs portfolio while 1e repre-
sents the payment made by the mortgagor. In
Fig. 1, 1f is the mortgage loan guarantee fee pay-
ments to the guarantor by the servicer (bank) of the
securitized mortgage loan. Finally, 1g represents
payments made by the guarantor in the case where
mortgagors default.
In our article, we introduce a Levy process-based
model of bank leverage profit under mortgage loan
securitization. Here, leverage refers to the degree to
which the bank utilizes borrowed money. Banks
that are highly leveraged may be at risk of failure
if they are unable to make debt payments or find
new lenders in the future. Leverage profit (also
called financial leverage profit) refers to the
mechanism whereby the bank creates profit by
leveraging itself. We note that our contribution dif-
fers from Mukuddem-Petersen et al. (2008) in that
it investigates the dynamics of bank leverage profit
from securitization activities while Mukuddem-
Petersen et al. (2008) studied the bank profit
which arises from both on- and off-balance sheet
activities.
A motivation for studying the aforementioned topic
is to extend discrete-time models used in the analysis
of subprime credit (see, e.g., Altug and Labadie, 1994;
Chami and Cosimano, 2001) to a more general class of
models. Despite the extent of the existing literature on
these issues, the use of discrete-time banking models
M. A. Petersen et al.
beyond two periods is limited. A further motivation is
the fact that profitability is a major indicator of finan-
cial crises for households, companies and financial
institutions (Demirgüc-Kunt and Detragiache, 1999;
Mukuddem-Petersen et al., 2008). An example of the
latter, from the SMC, is that both the failure of the
Lehmann Brothers investment bank and the acquisi-
tion in September 2008 of Merrill Lynch and Bear
Stearns by Bank of America and JP Morgan, respec-
tively, was preceded by a decrease in leverage
profitability. A similar trend was discerned for the
US mortgage companies, the Federal National
Mortgage Association (Fanie Mae) and Federal
Home Loan Mortgage Corporation (Freddie Mac),
who had to be bailed out by the US government at
the beginning of September 2008. By way of addres-
sing the aforementioned issues, we construct stochas-
tic models for mortgage loans, loan losses, credit
ratings, mortgage loan guarantees and securitization
in a subprime setting. From these models, we deduce a
stochastic dynamic model for bank leverage profit
under securitization of a pool of mortgage loans. In
this article, the costs of the guarantee is related to
transaction costs to participate in the guarantee pro-
gramme like the open or study rate (usually paid only
once) and the maintenance rate (paid annually in
proportion to the credit risk). In conclusion, our arti-
cle provides a brief analysis of some of the financial
modelling issues and their connections with the SMC
as well as possible future investigations.
The problem that we address in our article may be
stated as follows.
Problem 1 (Modelling of bank leverage profit under
mortgage loan securitization): Can we construct a Levy
 Dynamic modelling of bank leverage profit under loan securitization
process-based model to describe bank leverage profit
under mortgage loan securitization? (‘Bank leverage
profit under mortgage loan securitization’).
II. Subprime Banking Models
In this section, we first discuss SMC. Then we construct
a stochastic model of the bank leverage profit under
securitization of a pool of mortgage loans. To model
the uncertainty associated with these items, we consider
the filtered probability space, ð; F; ðF t Þ0tT ; PÞ,
throughout.
Subprime mortgage credit
Downloaded by [Columbia University] at 19:41 14 November 2014
In this subsection, we consider the mortgage loans,
loan losses, credit ratings, mortgage loan guarantees
and securitization in the context of the SMC.
Subprime mortgage loans. A subprime mortgage
loan is a loan granted to mortgagors who do not
qualify for market interest rates owing to various
risk factors, such as income level, size of the down
payment made, credit history and employment status.
Approximately 80% of US mortgages issued in the
last 5 years to subprime mortgagors were Adjustable-
Rate Mortgages (ARMs). When US house prices
began to decline in 2006–2007, refinancing became
more difficult and as ARMs began to reset at higher
rates, mortgage delinquencies soared. Securities
backed with subprime mortgages, widely held by
financial firms, lost most of their value. The result
has been a large decline in the capital of many banks
and US government-sponsored enterprises (e.g.
Fannie Mae and Freddie Mac) and a tightening of
credit around the world.
In the sequel, we suppose that, after providing
liquidity, the bank lends in the form of subprime
mortgage loans, t, at the bank’s own adjustable loan
rate, rt . This loan rate, for profit-maximizing banks, is
determined as follows:
et ¼ rt  rt
where rt is the base rate and et is the risk premium.
In the sequel, we define the Levy–Itô decomposition
associated with the subprime mortgage loans by
Zt Z

Lt ¼ a t þ b 
Zt þ  e
yMðds; dyÞ
0 <
1471
where a ¼ E½L1 ; ðb Zt Þ0t is a Brownian
motion with SD, b  0. From Equation 2 it follows
that
Z
dLt ¼ a dt þ b dZt þ   e
yMðdt; dyÞ
<
Furthermore, we have that
e
Mðdt; dyÞ ¼ Mðdt; dyÞ  ðdyÞdt;
is the compensated Poisson random measure on
[0, 1) · < \ {0} related to Lt, M (dt, du) is the Poisson
random measure on <+ · < \ {0} with intensity mea-
sure dt · . Here dt is the Lebesgue measure and  is the
Levy measure. The measure dt ·  (or sometimes just )
is called the compensator of M (dt, dy).
Because of the expenses related to monitoring and
screening, we assume that subprime mortgage loans
incur a constant marginal cost, c . Then the stochastic
dynamics of the subprime mortgage loan price pro-
cess, P, may be described via a geometric Levy
process as
 Z 
e
dPt ¼ Pt t dt þ t dZt þ t yt Mðdt; dyÞ ð3Þ
<
where t ¼ rt  ct þ at , t ¼ t bt and t ¼ t  t
are the total expected return, volatility and constant
jump coefficient, respectively. In addition, Zt is a stan-
dard Brownian motion with respect to a filtration,
ðF t Þt0 , of the probability space ð; F; ðF t Þ0tT ; PÞ.
Subprime mortgage loan losses. In this subsection,
we discuss random (unexpected) primary and second-
ary mortgage loan losses. In addition, we shall express
the total unexpected mortgage loan losses as the sum
of primary and secondary losses. The settlement pro-
cess related, for instance, to securitization during the
SMC may also involve multiple losses in the form of
write-downs, restitution, legal liability, fines and
others. For example, the bankruptcy of Lehman
ð1Þ Brothers (due to primary losses) caused secondary
losses via a depreciation in the price of commercial
real estate. Fears of the bank liquidating its holdings
in such real estate led to other holdings being sold in
anticipation. Furthermore, many banks, real estate
investment trusts and hedge funds suffered significant
secondary losses during the SMC as a result of mort-
ð2Þ gage payment defaults or mortgage asset devaluation
(primary losses).
 1472
In the sequel, we assume that both unexpected
primary and secondary losses are recorded at the
times
0 ¼ T0 <T1 <T2 <T3 <   
where the corresponding unexpected primary and
secondary losses amounts are described by the non-
negative random variables l p1 <l p2 <l p3 <    and
l s1 <l s2 <l s3 <    , respectively. In particular, we
call these random variables the size of unexpected
primary and secondary losses. Let
Nt ¼ supfn  1 : Tn <tg; supðÞ;0
be the number of mortgage loan losses recorded dur-
ing the interval [0, t]. The aggregate unexpected mort-
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M. A. Petersen et al.
their subprime mortgage loans and hence to calculate
minimum capital requirements. In the sequel,
; 0  ðtÞ  1;
is a credit rating compensatory term that coincides with
the actual rating of the subprime mortgage loans by a
Credit Rating Agency. In principle, the value of rises
when perceived credit risk (probability of default) is low
and decreases when perceived credit risk is high.
However, in general, there is substantial evidence to
suggest that credit rating changes exhibit procyclical
behaviour or systematic variation (see, e.g., Borio et al.,
2001). This phenomenon accentuates the difference
between perceived and actual credit risk. For instance,
in the period before the SMC, procyclicality caused the
value of to rise even though actual credit risk was high.

gage loan losses is modelled by a compound Poisson

process as Subprime mortgage loan guarantees. The investment
 in MBSs may yield substantial returns but may also
Spt þ Sst ; Nt >0 result in losses as suggested in section ‘Subprime
St ¼ ð4Þ
0; Nt ¼ 0 mortgage loan losses.’ The party that suffers from
these losses are the investors in MBSs. In this regard,
where our dynamic model allows for mortgage loan losses
for which guarantee payments against loan losses can
X
Nt X
Nt be made. In other words, we assume that in the process
Spt lpj s
t ; St ¼ Ssjt and St ¼ Spt þ Sst of servicing the MBSs, the bank pays guarantee fees to
j¼1 j¼1
the guarantor. When a mortgagor defaults, the guar-
X
Nt X
Nt
antor covers the mortgage loan losses faced by inves-
¼ lmj
t ¼ ðlpj sj
t þ lt Þ
j¼1 j¼1
tors in MBSs. The accompanying default risk is
modelled as a compound Poisson process where N e is
Here ðlmn Þn2N is a sequence, independent of N, of a Poisson process with a deterministic frequency para-
meter, (t). Here, N e is stochastically independent of
positive i.i.d. random variables with a distribution
function F and a mean  = E[lm] , 1, modelling the Brownian motion, Z, given in Equation 3.
the values of the unexpected mortgage loan losses. Furthermore, we assume that the guarantee for mort-
The times between mortgage loan losses gage loan losses takes the form of a continuous con-
tribution that can be expressed as
Tn  Tn1 ; n1
½1  ðuÞ ðuÞE½Gu ðSs Þ ð5Þ
are i.i.d. exponentially distributed random variables
with parameter  . 0. The processes (Tn)n1 and where  is given as above, Ss is the secondary mortgage
(lmn)n1 are independent. It follows that the unexpected loan losses and Gt is the actual guarantee for such loan
mortgage loan loss number process, N = (Nt)t0, losses. This means that if the investor suffers a loss of
is a homogeneous Poisson process with an intensity Ss = l at time t, the guarantee, Gt(l), covers these losses.
 . 0, i.e., The actual manner in which the bank pays the guaran-
tee for mortgage loan losses can differ greatly.
ðtÞi
PðNt ¼ iÞ ¼ expftg ; i ¼ 0; 1; 2; . . . Bank leverage profit under mortgage loan
i!
securitization
so that (St)t0 is a compound Poisson process. Following the work in Fouche et al. (2008), let

represent the fraction of securitized mortgage loans.

Credit ratings. Concerns about credit ratings have Then 1 –
denotes the fraction of unsecuritized mort-
resurfaced during the SMC, where banks have been gage loans, where
 [0, 1]. In the sequel, when
= 0
allowed to use ratings to determine the risk attached to then 100% of a portfolio of mortgage loans is
 Dynamic modelling of bank leverage profit under loan securitization
unsecuritized. On the other hand, if
= 1, then 100% III. Dynamic Subprime Modelling Issues
of the mortgage loan portfolio is securitized as in the
case of true-sales securitization.
In the securitization process, the bank sells the pool
of mortgage loans to the investors at the transaction
(securitization) cost, cs. By prior agreement, the inves-
tor will be entitled to part of the mortgage loan pay-
ments. This is as if the bank sold the interest rates on
mortgage loans to the investors or as borrowing
against the pool of mortgage loans. As was mentioned
before, the bank collects mortgage payments; extracts
servicing fees, f s; pays guarantee fees (see Section
‘Subprime mortgage loan guarantees’ above) to the
guarantor and pays the interest rate, rI, to investors.
Below, we denote the mortgage loan rate by r, the
rate of cash flow from the bank for financing the
portfolio of unsecuritized mortgage loans by rc, the
Downloaded by [Columbia University] at 19:41 14 November 2014
1473
and their Connections with the Subprime
Mortgage Crisis
In this section, we briefly discuss some issues ema-
nating from the subprime banking models and their
relationship with the SMC. This crisis is character-
ized by shrinking liquidity in global credit markets
and banking systems. A downturn in the US hous-
ing market, risky practices by lenders and borrowers
and excessive individual and corporate debt levels
have affected the world economy adversely on a
number of levels. The SMC has exposed pervasive
weaknesses in the global financial system and reg-
ulatory framework.
Subprime mortgage credit

total expected return by  , the marginal cost of

securitization by cs, the servicing fee for mortgage The risk premium, et, from Equation 1 has had a part
loans by f s, the interest rate paid to investors by rI, to play in the SMC. This premium is part of the
the fraction of securitized mortgage loans by
, the dynamic of mortgage loan price in Equation 3 via
primary mortgage loan loss by S p and the secondary the bank’s own adjustable loan rate, rt , and its size is
mortgage loan loss by Ss. In this case, the stochastic an indication of perceived credit risk. According to a
study by the US Federal Reserve, the average differ-
model of bank leverage profit, which incorporates
ence in mortgage interest rates between subprime
both unsecuritized and securitized mortgage loans,
~ at time, u  t, may be given by (‘subprime markup’) and prime mortgages declined
,
from et = 2.8 percentage points (280 basis points) in
  2001 to et = 1.3 percentage points in 2007. In other
~ u ¼ ð
d uu  cs  fs  rIu Þ
u þ ðu  fs Þð1 
Þu
 words, the risk premium, et, required by lenders to
þIu  ½ku þ rcu   ½1  ðÞ ðuÞE½Gu ðSs Þ du offer a subprime loan declined dramatically during
þ  u dZu þ  u the aforementioned period (see, Wikipedia, 2009 e.g.,
Z for more information). This occurred even though the
e
yMðdu; eu ;
dyÞ  Sp ðu ; uÞ dN credit ratings of subprime borrowers and subprime
< loan quality declined overall during the period 2001
u  t; 0 
 1; ~ t ¼ 
 ð6Þ to 2006. In fact, this state of affairs should have had
the effect of increasing the risk premium, et, from
The stochastic model of unsecuritized bank profit, where Equation 1. However, it is clear that the combination

= 0, Gu(Ss) = 0 and ku = 0 in Equation 6 is given by of declining risk premia and credit standards is con-
sistent with boom and recession fluctuations to be
   found in credit cycles (Demyanyk and Van Hemert,
dns u  fs Þu  rcu du þ  u dZu þ  u
u ¼ ð
Z 2008).
e
yMðdu; dyÞ  Sp ðu; uÞdNeu ; During the SMC, the probability of default on
< mortgage loans was very high. As a result, the interest
u  t; ns
t ¼
ð7Þ rate on mortgage loans in Equation 3 was at an ele-
vated level. In this situation, there was a natural reduc-
In our contribution, we note the special case of bank tion in the demand for mortgage loans. On other
leverage profit under true-sales securitization, where words, a high interest rate deterred potential bor-

= 1 and rc = 0 in Equations 6 and 7. Here, we have that rowers (individuals, businesses and corporations)
from applying for mortgage loans. On the other
hand, when the probability of default is lower, the

du ¼ ðu  cs  fs  rIu Þu þ Iu  ku  ½1  ðuÞ mortgage loan demand will increase as it would not
cost much for the borrowers to obtain loans (due to
ðuÞE½Gu ðSs Þdu þ  u dZu þ  u
Z lower interest rates).
e
yMðdu; dyÞSp ðIIu ; uÞdN eu ; u  t; IIt ¼  ð8Þ A combination of factors resulting from the SMC
< have led to problems in the commercial real estate
 1474 M. A. Petersen et al.
2 T
market as regards to loan demand. According to Z
t; 4
the National Association of Realtors there was a
slowing in the commercial real estate market due to
tightening credit and sluggish growth, the former a
direct result of the SMC. Although capital remained
available for residential loans, the credit crunch was
pronounced in commercial lending (see, e.g.,
Wikipedia, 2009 for more information).
Bank leverage profit under mortgage loan
securitization
In the previous section ‘Bank leverage profit under
mortgage loan securitization,’ we have seen that the
dynamic model of bank profit given by Equation 8
involves credit ratings and guarantee payment. In
this regard, our model shows that when the credit
Downloaded by [Columbia University] at 19:41 14 November 2014
ratings, (t), is high then the guarantee payment is
low because high credit ratings mean that a low
credit risk is associated with the MBSs. Low credit
risk will create liquidity in the credit market as
everyone will be more willing to lend. This liquidity
will cause some of the financial institutions to more
readily lend to subprime mortgagors because of
competition in the credit market. During the SMC,
a depreciation of house prices also contributed to a
decline in the profits of many banks in the USA. In
this regard, profits at the 8533 US banks insured
by the Federal Deposit Insurance Corporation fell
from $35.2 billion to $646 million (effectively by
89%) during fourth quarter of 2007 when compared
with the previous year. This was largely because of
escalating loan losses and provisions for loan losses.
This decline in profits contributed to the worst bank
and thrift quarterly performance since 1990. In
2007, these banks earned approximately $100 billion,
which represented a decline of 31% from the record
profit of $145 billion in 2006. Profits decreased
from $35.6 billion to $19.3 billion during the first
quarter of 2008 versus the previous year, a decline
of 46%.
In future, the dynamic model 8 could possibly be
used to study an optimal securitization problem,
which aims to optimize the rate of cash outflow,
k, and bank’s investment in MBSs, , for a fixed
term [t, T]. In this case, the objective function may
be given as
Jð; tÞ ¼ max E expfr ðu  tÞgUð1Þ ðku Þdu
fkt ;t g
t
#
r ð2Þ
þ expf ðT  tÞgU ðT Þ
where U(1) and U(2) are increasing, concave utility
functions and r . 0 is the rate at which the utility
functions of the rate of cash outflow and terminal
profit are discounted. In addition, we could also
extend our study by incorporating banking regula-
tion via the Basel II Capital Accord (Basel
Committee on Banking Supervision, 2006; Fouche
et al., 2008) because there is a strong connection
between asset securitization and minimum capital
regulatory requirements.
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