Rise And Fall Of Synthetic Cdo Market: Lessons Learned

This paper uses a unique data set of more than 1000 synthetic Collateralized Debt Obligations (CDOs) deals to describe typical structures, their pricing and performance with the aim of identifying the factors behind the spectacular collapse of this important segment of structured credit market in late 2008. The data suggests that mark-to-market losses on many synthetic CDO tranches were much more significant than in case of simpler, lower-rated products despite the former experiencing little or no impairment of the notional. The losses were driven instead by the concentration of relatively limited number of defaults in a short period of time, suggesting that pre-crisis pricing must have seriously underestimated such risk of default clustering. In view of the post-crisis pick-up in synthetic CDO issuance, the paper attempts to heed this lesson and offer a simple factor model of default correlation in the spirit of Marshall–Olkin that is naturally suited to capturing the temporal dimension of default dependencies that have been crucial for synthetic CDOs investors. The model allows building a rich dependence structure capable of consistently fitting standardized iTraxx and CDX index tranches, which makes it ideal for pricing bespoke CDOs.