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Risk Transfer with CDOs

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  • Jan Pieter Krahnen

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  • Christian Wilde

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Abstract

Modern bank management comprises both classical lending business and transfer of asset risk to capital markets through securitization. Sound knowledge of the risks involved in securitization transactions is a prerequisite for solid risk management. This paper aims to resolve a part of the opaqueness surrounding credit-risk allocation to tranches that represent claims of different seniority on a reference portfolio. In particular, this paper analyzes the allocation of credit risk to different tranches of a CDO transaction when the underlying asset returns are driven by a common macro factor and an idiosyncratic component. Junior and senior tranches are found to be nearly orthogonal, motivating a search for the where about of systematic risk in CDO transactions. We propose a metric for capturing the allocation of systematic risk to tranches. First, in contrast to a widely-held claim, we show that (extreme) tail risk in standard CDO transactions is held by all tranches. While junior tranches take on all types of systematic risk, senior tranches take on almost no non-tail risk. This is in stark contrast to an untranched bond portfolio of the same rating quality, which on average suffers substantial losses for all realizations of the macro factor. Second, given tranching, a shock to the risk of the underlying asset portfolio (e.g. a rise in asset correlation or in mean portfolio loss) has the strongest impact, in relative terms, on the exposure of senior tranche CDO-investors. Our findings can be used to explain major stylized facts observed in credit markets.

Suggested Citation

  • Jan Pieter Krahnen & Christian Wilde, 2008. "Risk Transfer with CDOs," Working Paper Series: Finance and Accounting 187, Department of Finance, Goethe University Frankfurt am Main.
  • Handle: RePEc:fra:franaf:187
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    References listed on IDEAS

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    1. Gunter Franke & Jan Pieter Krahnen, 2007. "Default Risk Sharing between Banks and Markets: The Contribution of Collateralized Debt Obligations," NBER Chapters,in: The Risks of Financial Institutions, pages 603-634 National Bureau of Economic Research, Inc.
    2. Peter M. DeMarzo, 2005. "The Pooling and Tranching of Securities: A Model of Informed Intermediation," Review of Financial Studies, Society for Financial Studies, vol. 18(1), pages 1-35.
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    Cited by:

    1. Wojtowicz, Marcin, 2014. "CDOs and the financial crisis: Credit ratings and fair premia," Journal of Banking & Finance, Elsevier, vol. 39(C), pages 1-13.
    2. Gann, Philipp, 2009. "Liquidität, Risikoeinstellung des Kapitalmarktes und Konjunkturerwartung als Preisdeterminanten von Collateralized Debt Obligations (CDOs) - Eine simulationsgestützte Analyse," Discussion Papers in Business Administration 10582, University of Munich, Munich School of Management.
    3. repec:dug:actaec:y:2017:i:2:p:102-121 is not listed on IDEAS
    4. Francis A. Longstaff & Brett Myers, 2009. "Valuing Toxic Assets: An Analysis of CDO Equity," NBER Working Papers 14871, National Bureau of Economic Research, Inc.
    5. Scholz, Julia, 2009. "Collateralized Debt Obligations: Anreizprobleme im Rahmen des Managements von CDOs," Discussion Papers in Business Administration 11002, University of Munich, Munich School of Management.
    6. D. COLANDER & al., 2010. "The Financial Crisis and the Systemic Failure of Academic Economics," VOPROSY ECONOMIKI, N.P. Redaktsiya zhurnala "Voprosy Economiki", vol. 6.
    7. Alper Kara & Aydin Ozkan & Yener Altunbas, 2016. "Securitisation and banking risk: what do we know so far?," Review of Behavioral Finance, Emerald Group Publishing, vol. 8(1), pages 2-16, June.
    8. Lin, Justin Yifu & Treichel, Volker, 2012. "The crisis in the Euro zone : did the euro contribute to the evolution of the crisis ?," Policy Research Working Paper Series 6127, The World Bank.
    9. Günter Franke & Jan P. Krahnen, 2009. "Instabile Finanzmärkte," Perspektiven der Wirtschaftspolitik, Verein für Socialpolitik, vol. 10(4), pages 335-366, November.
    10. Hartmann-Wendels, Thomas, 2008. "Die Finanzmarktkrise: Ursachen und Auswirkungen auf die Leasing-Branche," Leasing - Wissenschaft & Praxis, Universität zu Köln, Forschungsinstitut für Leasing, vol. 6(2), pages 3-17.
    11. Ingo Fender & Janet Mitchell, 2009. "Incentives and tranche retention in securitisation: a screening model," BIS Working Papers 289, Bank for International Settlements.
    12. Marcin Wojtowicz, 2011. "CDOs and the Financial Crisis: Credit Ratings and Fair Premia," Tinbergen Institute Discussion Papers 11-022/2/DSF 8, Tinbergen Institute.
    13. Kara, Alper & Marques-Ibanez, David & Ongena, Steven, 2015. "Securitization and Credit Quality," International Finance Discussion Papers 1148, Board of Governors of the Federal Reserve System (U.S.).
    14. repec:ces:ifodic:v:6:y:2008:i:3:p:14567230 is not listed on IDEAS
    15. Deming Wu & Jiawen Yang & Han Hong, 2011. "Securitization and Banks’ Equity Risk," Journal of Financial Services Research, Springer;Western Finance Association, vol. 39(3), pages 95-117, June.
    16. Franke, Günter & Krahnen, Jan Pieter, 2008. "The future of securitization," CFS Working Paper Series 2008/31, Center for Financial Studies (CFS).
    17. Jeong-Bon Kim & Li Li & Mary L. Z. Ma & Frank M. Song, 2013. "CEO Option Compensation, Risk-Taking Incentives, and Systemic Risk in the Banking Industry," Working Papers 182013, Hong Kong Institute for Monetary Research.
    18. Gunther Tichy, 2010. "War die Finanzkrise vorhersehbar?," Perspektiven der Wirtschaftspolitik, Verein für Socialpolitik, vol. 11(4), pages 356-382, November.
    19. Ongena, Steven & Kara, Alper & Marqués-Ibáñez, David, 2011. "Securitization and lending standards: evidence from the wholesale loan market," Working Paper Series 1362, European Central Bank.
    20. Bernd Rudolph & Julia Scholz, 2008. "Driving Factors of the Subprime Crisis and Some Reform Proposals," ifo DICE Report, ifo Institute - Leibniz Institute for Economic Research at the University of Munich, vol. 6(3), pages 14-19, October.
    21. Arndt Claußen & Sebastian Löhr & Daniel Rösch, 2014. "An analytical approach for systematic risk sensitivity of structured finance products," Review of Derivatives Research, Springer, vol. 17(1), pages 1-37, April.
    22. Di Cesare, Antonio, 2009. "Securitization and Bank Stability," MPRA Paper 16831, University Library of Munich, Germany.
    23. Michalak, Tobias C. & Uhde, André, 2012. "Credit risk securitization and bank soundness in Europe," The Quarterly Review of Economics and Finance, Elsevier, vol. 52(3), pages 272-285.
    24. Kara, Alper & Marques-Ibanez, David & Ongena, Steven, 2016. "Securitization and lending standards: Evidence from the European wholesale loan market," Journal of Financial Stability, Elsevier, vol. 26(C), pages 107-127.
    25. Scholz, Julia, 2009. "Collateralized Debt Obligations: Anreizprobleme im Rahmen des Managements von CDOs," Discussion Papers in Business Administration 10999, University of Munich, Munich School of Management.

    More about this item

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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