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CDOs and the Financial Crisis: Credit Ratings and Fair Premia

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  • Marcin Wojtowicz

    (VU University Amsterdam)

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    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.

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    File URL: http://papers.tinbergen.nl/11022.pdf
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    Bibliographic Info

    Paper provided by Tinbergen Institute in its series Tinbergen Institute Discussion Papers with number 11-022/2/DSF 8.

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    Date of creation: 04 Feb 2011
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    Handle: RePEc:dgr:uvatin:20110022

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    Web page: http://www.tinbergen.nl

    Related research

    Keywords: Collateralized debt obligations; Credit ratings; Fair premia; Structured finance; Rating agencies;

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    Cited by:
    1. Vittorio Corbo & Klaus Schmidt-Hebbel, 2013. "The International Crisis and Latin America," Monetaria, Centro de Estudios Monetarios Latinoamericanos, vol. 0(1), pages 37-62, January-j.
    2. repec:cml:moneta:v:i:y:2013:i:1:p:167-198 is not listed on IDEAS
    3. 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, vol. 0(1), pages 87-165, January-j.
    4. Guillermo Calvo & Alejandro Izquierdo & Rudy Loo-Kung, 2013. "Optimal Holdings of International Reserves: Self-insurance against Sudden Stops," Monetaria, Centro de Estudios Monetarios Latinoamericanos, vol. 0(1), pages 1-35, January-j.
    5. Eduardo Levy Yeyati, 2013. "Things We Learn from Crises," Monetaria, Centro de Estudios Monetarios Latinoamericanos, vol. 0(1), pages 199-230, January-j.
    6. repec:cml:moneta:v:i:y:2013:i:1:p:63-85 is not listed on IDEAS
    7. repec:cml:moneta:v:i:y:2013:i:1:p:87-165 is not listed on IDEAS
    8. repec:cml:moneta:v:i:y:2013:i:1:p:1-35 is not listed on IDEAS
    9. João Pedro Bumachar Resende & Ilan Goldfajn, 2013. "Latin America During the Crisis: The Role of Fundamentals," Monetaria, Centro de Estudios Monetarios Latinoamericanos, vol. 0(1), pages 167-198, January-j.
    10. repec:cml:moneta:v:i:y:2013:i:1:p:37-62 is not listed on IDEAS
    11. repec:cml:moneta:v:i:y:2013:i:1:p:199-230 is not listed on IDEAS
    12. Allan Hernández & Alberto Trejos, 2013. "Fiscal Moral Hazard Due to Monetary Integration," Monetaria, Centro de Estudios Monetarios Latinoamericanos, vol. 0(1), pages 63-85, January-j.

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