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The Economics of Structured Finance

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  • Joshua Coval
  • Jakub Jurek
  • Erik Stafford

Abstract

This paper investigates the spectacular rise and fall of structured finance. The essence of structured finance activities is the pooling of economic assets like loans, bonds, and mortgages, and the subsequent issuance of a prioritized capital structure of claims, known as tranches, against these collateral pools. As a result of the prioritization scheme used in structuring claims, many of the manufactured tranches are far safer than the average asset in the underlying pool. This ability of structured finance to repackage risks and to create "safe" assets from otherwise risky collateral led to a dramatic expansion in the issuance of structured securities, most of which were viewed by investors to be virtually risk-free and certified as such by the rating agencies. At the core of the recent financial market crisis has been the discovery that these securities are actually far riskier than originally advertised. We examine how the process of securitization allowed trillions of dollars of risky assets to be transformed into securities that were widely considered to be safe. We highlight two features of structured finance products - the extreme fragility of their ratings to modest imprecision in evaluating underlying risks, and their exposure to systematic risks - that go a long way in explaining the spectacular rise and fall of structured finance. We conclude with an assessment of what went wrong and the relative importance of rating agency errors, investor credulity, and perverse incentives and suspect behavior on the part of issuers, rating agencies, and borrowers.

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Bibliographic Info

Article provided by American Economic Association in its journal Journal of Economic Perspectives.

Volume (Year): 23 (2009)
Issue (Month): 1 (Winter)
Pages: 3-25

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Handle: RePEc:aea:jecper:v:23:y:2009:i:1:p:3-25

Note: DOI: 10.1257/jep.23.1.3
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  1. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, American Finance Association, vol. 29(2), pages 449-70, May.
  2. Jorion, Philippe & Zhang, Gaiyan, 2007. "Good and bad credit contagion: Evidence from credit default swaps," Journal of Financial Economics, Elsevier, Elsevier, vol. 84(3), pages 860-883, June.
  3. Ederington, Louis H. & Goh, Jeremy C., 1998. "Bond Rating Agencies and Stock Analysts: Who Knows What When?," Journal of Financial and Quantitative Analysis, Cambridge University Press, Cambridge University Press, vol. 33(04), pages 569-585, December.
  4. Katz, Steven, 1974. "The Price Adjustment Process of Bonds to Rating Reclassifications: A Test of Bond Market Efficiency," Journal of Finance, American Finance Association, American Finance Association, vol. 29(2), pages 551-59, May.
  5. Holthausen, Robert W. & Leftwich, Richard W., 1986. "The effect of bond rating changes on common stock prices," Journal of Financial Economics, Elsevier, Elsevier, vol. 17(1), pages 57-89, September.
  6. Hull, John & Predescu, Mirela & White, Alan, 2004. "The relationship between credit default swap spreads, bond yields, and credit rating announcements," Journal of Banking & Finance, Elsevier, Elsevier, vol. 28(11), pages 2789-2811, November.
  7. Hand, John R M & Holthausen, Robert W & Leftwich, Richard W, 1992. " The Effect of Bond Rating Agency Announcements on Bond and Stock Prices," Journal of Finance, American Finance Association, American Finance Association, vol. 47(2), pages 733-52, June.
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Blog mentions

As found by EconAcademics.org, the blog aggregator for Economics research:
  1. Rating the Agencies
    by Rajiv in Rajiv Sethi on 2011-08-06 17:13:00
  2. Structural product rating and sensitivity to mismeasurement
    by Economic Logician in Economic Logic on 2009-05-28 08:28:00
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