In the wake of the financial crisis, many once-esoteric investment terms have become a familiar part of our vocabulary. The role of structured finance securities such as collateralized debt obligations (CDOs), for example, and the part played by ratings agencies in legitimizing these products, has become all too clear. The pooling and repackaging of economic assets such as loans, bonds, and mortgages resulted in enormous yields for many investors—until, one day, they didn't.
"The Economics of Structured Finance," a paper [PDF
] forthcoming in the Journal of Economic Perspectives
, offers a close examination and clear explanation of how the process of securitization transformed trillions of dollars of risky assets into securities that many considered to be a safe bet. Authored by HBS professors Joshua D. Coval and Erik Stafford, with Jakub Jurek (HBS PhDBE '08), an assistant professor at Princeton University, the paper analyzes the difficulties of rating structured finance assets and the perils of relying on ratings to determine prices.
"We began studying the corporate bond CDO market roughly three years ago and reached the conclusion that it appeared to be severely mispriced," Coval remarks. "But we didn't have any sense that it would all come crashing down the way it did—we just thought that the mispricing would be corrected gradually."
Stafford adds that neither he nor Coval had done much work in the area of credit markets—yet these markets were growing at such an unprecedented rate that it piqued their curiosity. "People didn't explain anything about CDOs in a compelling way," he says. "They said, 'Oh, they're slicing and dicing.' Or they resorted to mathematical descriptions that were lacking any economic explanation as to why this product was so superior to other channels of financing. We also started hearing the phrase, 'These structures create yield out of thin air.' It implies magic, or a violation of a very standard notion in finance, a Modigliani-Miller proposition that the way you finance something is irrelevant to the value of the assets."
In their paper, the authors recount how, over the past decade, risks have been repackaged to create triple-A-rated securities. By mid-2007, they write, 37,000 structured finance issues in the United States had earned this top mark. In 2006, Moody's reported that 44 percent of its revenues came from rating structured finance products, versus the 32 percent of revenues generated from its traditional business of rating corporate bonds.
A simulation is "still a model and it's not exact, which is easy to forget."
Yet the paper presents a modeling exercise (using the same computer tools employed by the ratings agencies) that demonstrates that the challenge of rating structured products lies in their extreme sensitivity to estimation errors—that even modest imprecision in estimating underlying risks is magnified disproportionately when securities are pooled and tranched. Their simulation uses pools consisting of 100 bonds with a five-year default probability of 5 percent and a recovery rate of 50 percent of face value conditional on default.
Within each pool, the exercise creates a capital structure consisted of junior, mezzanine, and senior tranches. The junior tranche absorbs losses from the pool until the portfolio loss exceeds 6 percent, at which point it becomes worthless. The mezzanine tranche begins to absorb losses at that point, continuing to do so until the portfolio loss reaches 12 percent, with the senior tranche absorbing losses in excess of 12 percent. The scholars also run a simulation that constructs a "CDO²" by further dividing the mezzanine tranches, noting that due to the practice of subdividing large pools of residential mortgages, many CDOs of mortgage-backed securities were essentially CDO²s. That, coupled with the increase in subprime mortgages—from $96.8 billion in 1996 to approximately $600 billion in 2006—created a recipe for economic disaster.
The exercise clearly shows how the sensitivity of tranches to error in the estimate of default probability is determined by their seniority. An increase in the default probability from 5 percent to 10 percent results in a 55 percent decline in the expected payoff for the junior tranche, an 8 percent decline for the mezzanine tranche, and a .01 percent decline for the senior tranche. The effect is amplified in the CDO², with the value of the junior and mezzanine tranches falling quickly toward zero and the value of the senior tranche declining substantially as default probabilities rise. Earlier in their paper, however, the researchers illustrate the difficulty of estimating the default rate and assigning investment ratings of comparatively straightforward corporate bonds by citing 10-year historical data from Fitch on their default probability. Within the 10 investment grade rating categories of AAA to BBB-, the annualized default rate only varies between .02 and .75 percent, leaving little margin for error. The speculative grade range (from BB+ to C), meanwhile, has a default rate ranging from 1.07 percent to 29.96 percent.
Yet the ratings agencies aren't entirely at fault. "You can blame them a bit for going along with things and for overconfidence in their abilities," says Coval. "They were trying to rate these securities to the best of their abilities, and Wall Street kept telling them to rate more. They had a sense they were doing something wrong, but they were trying to improve their models as quickly as they could. I don't think they were deliberately manipulating the models to make them especially biased or imprecise." The computer simulations used to create the ratings are a standard tool, he says, adding that many would also describe it as a dangerous one because they create a false sense of confidence in what are essentially estimates.
"It's impossible to use a pencil and paper to characterize the interaction of a thousand different securities with different recovery rates and different business models," Stafford comments. "With a simulation you can get close to the right answer, but it's still a model and it's not exact, which is easy to forget. Often the people who are attracted to this approach are mathematicians, not economists, so they might not appreciate the underlying nature of some of the things they're describing." The paper notes that one neglected feature of the securities produced by structured finance is that it substitutes risks that are largely diversifiable for risks that are highly systematic, or linked to events in the economy. As a result, ratings of structured finance products, which make no distinction between the different sources of default risk, are particularly useless for determining prices and fair rates of compensation for these risks.
The paper also raises larger questions. "There has been a significant change in the price of these securities," says Coval. "How much of the repricing that's occurred was an elimination of mispricing that was prevalent prior to the crisis? How much of it was a spillover from the mortgage markets to markets that were fairly priced? And if there was a high degree of mispricing before the crisis, what impact did that have for the level of credit that was extended in the economy? How much of the $9 trillion of assets that entered these structures wouldn't have been originated in the first place if you hadn't been able to put them in these structures and 'create yield out of thin air'?
"That, to me, is probably the most important question as we think about how deep this crisis is going to go," Coval continues. "If the economy over the last 10 years had, say, a trillion dollars or more of credit extended than was appropriate, given the risks that were being borne, then we now need to go through a significant adjustment."
The inevitable question, of course, is what to change going forward. Coval advocates eliminating any sanction of ratings as a guide to investment policy and capital requirements. "Without that, there's no cover for that investor who says, 'I don't understand this product, but it's rated AAA, and my board will accept that as a good enough justification to hold it.' Over time, we've relied on these ratings and created a system where investors could outsource their due diligence."
Stafford cites the need to focus on measuring and judging the system's aggregate amount of leverage and understanding the exposures that financial institutions actually have. "We created institutions that are too big to fail, and that's largely because we didn't appreciate their size and leverage," he says. "Because of the focus on ratings, there was an ease of avoiding critical economic analysis throughout the whole system." As is so often the case with large failures, everyone—investors, ratings agencies, borrowers, and issuers—is a little bit to blame.