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CDOs and the Financial Crisis: Credit Ratings and Fair Premia

Author

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  • Marcin Wojtowicz

    (VU University Amsterdam)

Abstract

This paper uses the market-standard Gaussian copula model to show that fair spreads on CDO tranches are much higher than fair spreads on similarly-rated corporate bonds. It implies that credit ratings are not sufficient for pricing, which is surprising given their central role in structured finance markets. Tranche yield enhancement is attributed to a concentration of collateral bonds' risk premia in spreads of non-equity tranches. This illustrates limitations of the rating methodologies, which are solely based on estimates of real-world payoff prospects and thus do not capture risk premia. We also show that payoff prospects and credit quality of CDO tranches are characterized by low stability. If credit conditions deteriorate, then prices and ratings of CDO tranches are likely to fall substantially further than prices and ratings of corporate bonds. Default contagion exacerbates the pace and severity of changes for CDO tranches.

Suggested Citation

  • Marcin Wojtowicz, 2011. "CDOs and the Financial Crisis: Credit Ratings and Fair Premia," Tinbergen Institute Discussion Papers 11-022/2/DSF 8, Tinbergen Institute.
    • Handle: RePEc:tin:wpaper:20110022
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    References listed on IDEAS

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    1. Joshua Coval & Jakub Jurek & Erik Stafford, 2009. "The Economics of Structured Finance," Journal of Economic Perspectives, American Economic Association, vol. 23(1), pages 3-25, Winter.
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    6. Antje Berndt & Rohan Douglas & Darrell Duffie & Mark Ferguson, "undated". "Measuring Default Risk Premia from Default Swap Rates and EDFs," GSIA Working Papers 2006-E31, Carnegie Mellon University, Tepper School of Business.
    7. Maciej Firla-Cuchra, 2005. "Explaining Launch Spreads on Structured Bonds," Economics Series Working Papers 230, University of Oxford, Department of Economics.
    8. Efraim Benmelech & Jennifer Dlugosz, 2010. "The Credit Rating Crisis," NBER Chapters, in: NBER Macroeconomics Annual 2009, Volume 24, pages 161-207, National Bureau of Economic Research, Inc.
    9. Michael J. Brennan & Julia Hein & Ser†Huang Poon, 2009. "Tranching and Rating," European Financial Management, European Financial Management Association, vol. 15(5), pages 891-922, November.
    10. Ashcraft, Adam B. & Schuermann, Til, 2008. "Understanding the Securitization of Subprime Mortgage Credit," Foundations and Trends(R) in Finance, now publishers, vol. 2(3), pages 191-309, June.
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    Citations

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    Cited by:

    1. Vittorio Corbo & Klaus Schmidt-Hebbel, 2013. "The International Crisis and Latin America," Monetaria, CEMLA, vol. 0(1), pages 37-62, January-j.
    2. Allan Hernández & Alberto Trejos, 2013. "Fiscal Moral Hazard Due to Monetary Integration," Monetaria, Centro de Estudios Monetarios Latinoamericanos, CEMLA, vol. 0(1), pages 63-85, January-j.
    3. Grothe, Magdalena, 2013. "Market pricing of credit rating signals," Working Paper Series 1623, European Central Bank.
    4. Eduardo Levy Yeyati, 2013. "Things We Learn from Crises," Monetaria, Centro de Estudios Monetarios Latinoamericanos, CEMLA, vol. 0(1), pages 199-230, January-j.
    5. Eduardo Levy Yeyati, 2013. "Things We Learn from Crises," Monetaria, CEMLA, vol. 0(1), pages 199-230, January-j.
    6. Manuel Ramos -Francia & Ana María Aguilar-Argaez & Santiago García-Verdú & Gabriel Cuadra-García, 2013. "Heading into Trouble: A Comparison of the Latin American Crises and the Euro Area’s Current Crisis," Monetaria, Centro de Estudios Monetarios Latinoamericanos, CEMLA, vol. 0(1), pages 87-165, January-j.
    7. Allan Hernández & Alberto Trejos, 2013. "Fiscal Moral Hazard Due to Monetary Integration," Monetaria, CEMLA, vol. 0(1), pages 63-85, January-j.
    8. Guillermo Calvo & Alejandro Izquierdo & Rudy Loo-Kung, 2013. "Optimal Holdings of International Reserves: Self-insurance against Sudden Stops," Monetaria, Centro de Estudios Monetarios Latinoamericanos, CEMLA, vol. 0(1), pages 1-35, January-j.
    9. Manuel Ramos -Francia & Ana María Aguilar-Argaez & Santiago García-Verdú & Gabriel Cuadra-García, 2013. "Heading into Trouble: A Comparison of the Latin American Crises and the Euro Area’s Current Crisis," Monetaria, CEMLA, vol. 0(1), pages 87-165, January-j.
    10. João Pedro Bumachar Resende & Ilan Goldfajn, 2013. "Latin America During the Crisis: The Role of Fundamentals," Monetaria, Centro de Estudios Monetarios Latinoamericanos, CEMLA, vol. 0(1), pages 167-198, January-j.
    11. João Pedro Bumachar Resende & Ilan Goldfajn, 2013. "Latin America During the Crisis: The Role of Fundamentals," Monetaria, CEMLA, vol. 0(1), pages 167-198, January-j.
    12. Vittorio Corbo & Klaus Schmidt-Hebbel, 2013. "The International Crisis and Latin America," Monetaria, Centro de Estudios Monetarios Latinoamericanos, CEMLA, vol. 0(1), pages 37-62, January-j.

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    More about this item

    Keywords

    Collateralized debt obligations; Credit ratings; Fair premia; Structured finance; Rating agencies;
    All these keywords.

    JEL classification:

    • C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation, Validation, and Selection
    • G01 - Financial Economics - - General - - - Financial Crises
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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