Coval, Jurek & Stafford - The Economics of Structured Finance Flashcards
Two futures of the structured finance products that explains their failure.
- The extreme fragility of their ratings to modes imprecision in evaluating underlying risks; and
- Their exposure to systematic risks
The market for structured securities evolved as a “rated” market, in which the risk of tranches was assessed by credit rating agencies. Rating allowed
- issuers of structured finance products to have their new products rated on the same scale as bonds so that investors subject to ratings-based constraints would be able to purchase the securities.
- issuers to create an illusion of comparability with existing “single-name” securities
- issuers to access a large pool of potential buyers for what otherwise would have been perceived as very complex derivative securities
How to manufacturing AAA-rated Securities, assumptions made in order for the securities to be rated AAA.
The analyst can manufacture a range of securities with different cash flow risks, or tranches, against the portfolio of high-risk subprime mortgages.
These tranches should be prioritized in how they absorb losses and how they are paid. If no one defaults, all tranches will be paid. However, when monthly mortgage payments are not made, payments may not reach holders of junior tranches since senior tranches are paid firmst. Junior tranches, being risky, will have low prices and high promised returns. Senior tranches, being relatively safe, will have relatively high prices and lower promised returns.
The rating of the security is based on the anticipated likelihood of observing a default. The assumptions are that these high-risk subprime mortgage are not correlated with each other and they are not correlated with the market as a whole. Since the senior tranches are safeguarded by the junior tranches, as long as they are not correlated, the likelihood of observing a default in senior tranches could be low enough to qualify fro AAA rating. As correlation increases, the differentiation between the tranches diminishes. With perfect correlation, the tranching strategy produces no differentiation in risk between the tranches.
If probability of default is pD, Probabiliy of both default simultaneously is pDD, what is the default correlation?
Two ways to increase the total notional value of highly-reated securities.
- By using a larger number of securities in the underlying pool. As the number of bonds increase and the average correlation decreases, the portion of the combined structure that could achieve a high rating increases.
- Reapply the securitization machinery to the junior tranches created in the first round. The CDOs created from the tranches of other CDOs are typically called CDO2.
Why are the CDOs backed by mortgage-backed securites biased against the investor?
- the overlap in geographic locations and vintages within mortgage pools raised the prospect of higher-than-expected default correlations.
- the probability of default and the expected recovery values have both been worse than expected due to the deterioration in credit quality of subprime borrowers and assets being sold off under financial pressure further driving down the prices of related assets
- the prevalence of CDO2 structures further magnified the deleterious effects of errors in estimates of expected losses
Assess the role and impact of structured financial vehicles on the financial crisis of 2007-2008. (5pts)
- Structured finance vehicles artificially created a supply of credit at very low cost to the market. The demand for these vehicles was very high due to their perceived low risk (AAA-rated) and attractive yields compared to similar rated investments.
- CDOs allowed banks to be isolated from credit risk, because they could simply transfer the credit risk of the mortgages they were writing to investors. Hence, they had incentive to reduce underwriting standards to generate more loans.
- Many stakeholders did not understand the risk inherent in CDOs. Rating agencies failed to recognize how sensitive the instruments were to assumptions about default probabilities, recovery values, and correlation of defaults between each other and correlation with the market.
- CDO2s by their nature amplified the above problems. Also, synthetic CDOs artificially inflated the bubble as CDOs could be mimicked without the actual underlying assets.
- When the housing bubble burst, home prices decreased and many owners defaulted. This caused junior and mezzanien tranches to default, but losses also made their way to senior tranches that were perceived to be risk-free. Consequently, these tranches had their credti ratings downgraded which led to mark-to-market losses. They were often used as collateral, so calls for more collateral were made to compensate for the decreased value. At this point, funding in the market was scarce as banks got caught warehousing subprime mortgates to be repackaged, but there was no longer a market for them. A liquidity crisis ensued. A fire-sale of assets was necessary in order to meet collateral requirements.
Defend or Dispute the following statement:
“Credit rating agencies are to blame for the erosion of structured finance surrounding the events of 2007-2008.”
Acceptable reasons why credit rating agencies ARE to blame for the erosion of structured finance:
1) Rated/Evaluated CDOs and deemed them “safe”
2) Rating agencies used the same scale as single name (corporate bond) ratings, which was misleading to investors
3) Rating agencies failed to appreciate the fragility of their models, especially correlation/systematic risk
Acceptable reasons why credit rating agencies ARE NOT to blame for the erosion of structured finance:
1) Regulators & Investors bought into the ratings – they did not do their own due diligence / did not seek to validate or understand risks
2) Investment banks & rating agencies had perverse incentives to keep the machine running
3) Investors only focused on ratings – were not concerned that little to no underwriting was being done by originators
