A Little Knowledge Is a Dangerous Thing: Model Specification, Data History, and CDO (Mis)Pricing

Abstract

The revaluation of collateralized debt obligations (CDOs) plays a significant role in the ongoing 2007-2009 credit crisis. Starting in August 2007, a large amount of initially AAA rated CDO securities are substantially downgraded, some directly to junk grade. This paper explores two structural sources of CDO mispricing: modeling difficulty and data limitation. Simulating the frailty correlated default model of Duffie, Eckner, Horel, and Saita (2008), we show that CDO mis-pricing can be partly attributed to model misspecifications, as well as limited availability of historical data on CDO collateral assets. This simulation result is consistent with empirical evidence on historical performance of a sample of 279 CDOs. The frailty model estimated with adequate historical data would have reduced the amount of AAA rated CDO securities by 12% on average. The frailty model has predictive power for the subsequent downgrading of AAA rated CDO tranches. Our study addresses practical issues on financial innovations and provides guidance for corresponding risk management. * , a large amount of initially AAA rated CDO securities are substantially downgraded, some directly to junk grade. This paper explores two structural sources of CDO mispricing: modeling difficulty and data limitation. Simulating the frailty correlated default model of Duffie, Eckner, Horel, and Saita (2008), we show that CDO mis-pricing can be partly attributed to model misspecifications, as well as limited availability of historical data on CDO collateral assets. This simulation result is consistent with empirical evidence on historical performance of a sample of 279 CDOs. The frailty model estimated with adequate historical data would have reduced the amount of AAA rated CDO securities by 12% on average. The frailty model has predictive power for the subsequent downgrading of AAA rated CDO tranches. Our study addresses practical issues on financial innovations and provides guidance for corresponding risk management.

Customer Equity Sustainability Ratio: A New Metric for Assessing a Firm's Future Orientation

“…Each tranche receives a rating from a rating agency, from senior (AAA to A rating) to equity (no rating/residuum). Then, these tranches can be priced and sold to new investors (Coval, Jurek, and Stafford 2009; Luo, Tang, and Wang 2009), who receive all earnings from the tranche they own, which means they also confront any risks arising from the underlying loans (see Franke and Krahnen 2008).…”

“…First, the frequent repackaging and splitting of ABSs into tranches make it difficult to determine the appropriate value of those securities. This topic appears in extensive discussions elsewhere, so we do not detail it here (see Coval, Jurek, and Stafford 2009; Luo, Tang, and Wang 2009). Second, the short- and long-term effects of securitization are not equally transparent.…”

Did investors outsource their risk analysis to rating agencies? Evidence from ABS-CDOs

“…Studies analyzing the characteristics of CDO tranche loss distributions by simulations (e.g., Hamerle et al, 2009) generally find that traditional ratings are inadequate for CDOs since CDOs are much riskier investments than equally rated corporate bonds due to an increased sensitivity to systematic risks, and due to a higher calibration risk (Coval et al, 2009a). CDO ratings may also be inaccurate because of model misspecifications and data limitations (Luo et al, 2009), conflicts of interest resulting from rating agencies' ''issuer pays'' business model (Griffin and Tang, 2009), or issuers ''shopping'' for the best rating. 4 Despite their high prominence gained during the recent financial crisis, there is almost no empirical work on ABS-CDOs.…”