CDOs and the Financial Crisis: Credit Ratings and Fair Premia
AbstractThis 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.
Download InfoIf you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
Bibliographic InfoPaper provided by Tinbergen Institute in its series Tinbergen Institute Discussion Papers with number 11-022/2/DSF 8.
Date of creation: 04 Feb 2011
Date of revision:
Contact details of provider:
Web page: http://www.tinbergen.nl
Collateralized debt obligations; Credit ratings; Fair premia; Structured finance; Rating agencies;
Find related papers by 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
This paper has been announced in the following NEP Reports:
- NEP-ALL-2011-02-26 (All new papers)
- NEP-BAN-2011-02-26 (Banking)
- NEP-URE-2011-02-26 (Urban & Real Estate Economics)
You can help add them by filling out this form.
CitEc Project, subscribe to its RSS feed for this item.
- 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.
- repec:cml:moneta:v:i:y:2013:i:1:p:167-198 is not listed on IDEAS
- 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.
- Guillermo Calvo & Alejandro Izquierdo & Rudy Loo-Kung, 2013.
"Optimal Holdings of International Reserves: Self-insurance against Sudden Stops,"
Centro de Estudios Monetarios Latinoamericanos, vol. 0(1), pages 1-35, January-j.
- Guillermo A. Calvo & Alejandro Izquierdo & Rudy Loo-Kung, 2012. "Optimal Holdings of International Reserves: Self-Insurance against Sudden Stop," NBER Working Papers 18219, National Bureau of Economic Research, Inc.
- Eduardo Levy Yeyati, 2013. "Things We Learn from Crises," Monetaria, Centro de Estudios Monetarios Latinoamericanos, vol. 0(1), pages 199-230, January-j.
- repec:cml:moneta:v:i:y:2013:i:1:p:63-85 is not listed on IDEAS
- repec:cml:moneta:v:i:y:2013:i:1:p:87-165 is not listed on IDEAS
- repec:cml:moneta:v:i:y:2013:i:1:p:1-35 is not listed on IDEAS
- 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.
- repec:cml:moneta:v:i:y:2013:i:1:p:37-62 is not listed on IDEAS
- repec:cml:moneta:v:i:y:2013:i:1:p:199-230 is not listed on IDEAS
- 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.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Antoine Maartens (+31 626 - 160 892)).
If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.
If references are entirely missing, you can add them using this form.
If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.
If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.
Please note that corrections may take a couple of weeks to filter through the various RePEc services.