REAL ESTATE ECONOMICS Residential Mortgage Credit Derivatives

As the fallout from subprime losses clearly demonstrates, the credit risk in res idential mortgages is large and economically significant. To manage this risk, this article 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 hedg ing effectiveness, the analysis shows that instruments based on credit losses outperform contracts based on house price appreciation. The residential finance system has experienced a systemic failure. Mortgage securitization markets—the major source of mortgage finance—no longer func tion, except for those with implicit or explicit government credit guarantees. While the form that the future mortgage finance system will take is an open question, it is possible that private mortgage securitization will not recover and that portfolio lenders will have to provide a greater proportion of housing finance, and hence carry a greater proportion of the credit risk of residentia