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Constant Proportion Debt Obligations: A Postmortem Analysis of Rating Models

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  • Michael B. Gordy

    (Federal Reserve Board, Washington, DC 20551)

  • SØren Willemann

    (Barclays Capital, London E14 4BB, United Kingdom)

Abstract

In its complexity and its vulnerability to market volatility, the constant proportion debt obligation (CPDO) might be viewed as the poster child for the excesses of financial engineering in the credit market. This paper examines the CPDO as a case study in model risk in the rating of complex structured products. We demonstrate that the models used by Standard and Poor's (S&P) and Moody's fail in-sample specification tests even during the precrisis period and in particular understate the kurtosis of spread changes. Because stochastic volatility is the most natural explanation for the excess kurtosis, we estimate an extended version of the S&P model with stochastic volatility and find that the volatility-of-volatility is large and significant. An implication is that agency model-implied probabilities of attaining high spread levels were biased downward, which in turn biased the rating upward. We conclude with larger lessons for the rating of complex products and for modeling credit risk in general. This paper was accepted by Wei Xiong, finance.

Suggested Citation

  • Michael B. Gordy & SØren Willemann, 2012. "Constant Proportion Debt Obligations: A Postmortem Analysis of Rating Models," Management Science, INFORMS, vol. 58(3), pages 476-492, March.
    • Handle: RePEc:inm:ormnsc:v:58:y:2012:i:3:p:476-492
    DOI: 10.1287/mnsc.1110.1433
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    2. Lee, Hwang Hee & Hyun, Jung-Soon, 2019. "The asymmetric effect of equity volatility on credit default swap spreads," Journal of Banking & Finance, Elsevier, vol. 98(C), pages 125-136.
    3. Baghai, Ramin & Becker, Bo & Pitschner, Stefan, 2018. "The Private Use of Credit Ratings: Evidence from Mutual Fund Investment Mandates," CEPR Discussion Papers 13418, C.E.P.R. Discussion Papers.
    4. Baghai, Ramin P. & Becker, Bo, 2020. "Reputations and credit ratings: Evidence from commercial mortgage-backed securities," Journal of Financial Economics, Elsevier, vol. 135(2), pages 425-444.
    5. Baghai, Ramin P. & Becker, Bo, 2018. "Non-rating revenue and conflicts of interest," Journal of Financial Economics, Elsevier, vol. 127(1), pages 94-112.
    6. Agostino Capponi & Martin Larsson, 2014. "Will banning naked CDS impact bond prices?," Annals of Finance, Springer, vol. 10(3), pages 481-508, August.
    7. Michael B. Gordy & Pawel J. Szerszen, 2015. "Bayesian Estimation of Time-Changed Default Intensity Models," Finance and Economics Discussion Series 2015-2, Board of Governors of the Federal Reserve System (U.S.).
    8. Detering, Nils & Packham, Natalie, 2018. "Model risk of contingent claims," IRTG 1792 Discussion Papers 2018-036, Humboldt University of Berlin, International Research Training Group 1792 "High Dimensional Nonstationary Time Series".

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