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Securitisation Bubbles: Structured finance with disagreement about default correlations

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  • Broer, Tobias

Abstract

The early 2000s have seen an enormous boom and bust in structured financial products, such as residential mortgage-backed securities (RMBSs) or collateralised debt obligations (CDOs). The standard 'Gaussian Copula' model used to quantify their credit risk was highly dependent on the choice of a single default correlation parameter that often required subjective judgement, as underlying assets were not standardised or only had a short history. This paper shows how moderate disagreement about default correlation increases the market value of the structured collateral considerably above that of its total cash-flow, as investors self-select into buying tranches they value more highly than others. The implied 'return to tranching' is sizeable for a typical RMBS, and an order of magnitude larger for CDOs backed by RMBS-tranches, whose cash-flow distribution is not bounded by a minimum recovery value and thus more sensitive to heterogeneous default correlations. In contrast, disagreement about average default probabilities, or recovery values, does not imply a large return to tranching.

Suggested Citation

  • Broer, Tobias, 2016. "Securitisation Bubbles: Structured finance with disagreement about default correlations," CEPR Discussion Papers 11145, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:11145
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    References listed on IDEAS

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    Cited by:

    1. Broer, Tobias, 2018. "Securitization bubbles: Structured finance with disagreement about default risk," Journal of Financial Economics, Elsevier, vol. 127(3), pages 505-518.
    2. Dan Luo & Dragon Yongjun Tang & Sarah Qian Wang, 2018. "Model specification and collateralized debt obligation (mis)pricing," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 38(11), pages 1284-1312, November.

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    More about this item

    Keywords

    Cdo; Rmbs; Disagreement; Default correlation; Credit risk; Great recession; Housing bubble;
    All these keywords.

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search; Learning; Information and Knowledge; Communication; Belief; Unawareness
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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