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CDOs and systematic risk: Why bond ratings are inadequate

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  • Krahnen, Jan Pieter
  • Wilde, Christian

Abstract

This paper analyzes the risk properties of typical asset-backed securities (ABS), like CDOs or MBS, relying on a model with both macroeconomic and idiosyncratic components. The examined properties include expected loss, loss given default, and macro factor dependencies. Using a two-dimensional loss decomposition as a new metric, the risk properties of individual ABS tranches can directly be compared to those of corporate bonds, within and across rating classes. By applying Monte Carlo Simulation, we find that the risk properties of ABS differ significantly and systematically from those of straight bonds with the same rating. In particular, loss given default, the sensitivities to macroeconomic risk, and model risk differ greatly between instruments. Our findings have implications for understanding the credit crisis and for policy making. On an economic level, our analysis suggests a new explanation for the observed rating inflation in structured finance markets during the pre-crisis period 2004-2007. On a policy level, our findings call for a termination of the 'one-size-fits-all' approach to the rating methodology for fixed income instruments, requiring an own rating methodology for structured finance instruments. --

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Bibliographic Info

Paper provided by Center for Financial Studies (CFS) in its series CFS Working Paper Series with number 2009/11.

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Date of creation: 2009
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Handle: RePEc:zbw:cfswop:200911

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Keywords: Credit Risk; Risk Transfer; Systematic Risk;

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References

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  1. Peter M. DeMarzo, 2005. "The Pooling and Tranching of Securities: A Model of Informed Intermediation," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 18(1), pages 1-35.
  2. Guenter Franke & Jan Pieter Krahnen, 2005. "Default Risk Sharing Between Banks and Markets: The Contribution of Collateralized Debt Obligations," NBER Working Papers 11741, National Bureau of Economic Research, Inc.
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Cited by:
  1. Freixas, Xavier & Laux, Christian, 2011. "Disclosure, transparency, and market discipline," CFS Working Paper Series 2011/11, Center for Financial Studies (CFS).
  2. Lützenkirchen, Kristina & Rösch, Daniel & Scheule, Harald, 2013. "Ratings based capital adequacy for securitizations," Journal of Banking & Finance, Elsevier, Elsevier, vol. 37(12), pages 5236-5247.
  3. Mählmann, Thomas, 2013. "Hedge funds, CDOs and the financial crisis: An empirical investigation of the “Magnetar trade”," Journal of Banking & Finance, Elsevier, Elsevier, vol. 37(2), pages 537-548.
  4. Günter Franke & Jan P. Krahnen, 2009. "Instabile Finanzmärkte," Perspektiven der Wirtschaftspolitik, Verein für Socialpolitik, Verein für Socialpolitik, vol. 10(4), pages 335-366, November.

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