Coval, Joshua D. →

The Economics of Structured Finance

This paper investigates the spectacular rise and fall of structured finance. HBS professor Joshua Coval, Princeton professor Jakub Jurek, and HBS professor Erik Stafford begin by examining how the structured finance machinery works. They construct simple examples of collateralized debt obligations (CDOs) that show how pooling and tranching a collection of assets permits credit enhancement of the senior claims. They then explore the challenge faced by rating agencies, examining, in particular, the parameter and modeling assumptions that are required to arrive at accurate ratings of structured finance products. They conclude with an assessment of what went wrong and the relative importance of rating agency errors, investor credulity, and perverse incentives and suspect behavior on the part of issuers, rating agencies, and borrowers. Key concepts include: Small errors that would not be costly in the single-name market are significantly magnified by the collateralized debt obligation structure, and can be further magnified when CDOs are created from the tranches of other collateralized debt obligations, as was common in mortgage-backed securitizations. Explicitly acknowledging that parameters are uncertain would go a long way towards solving this problem. However, adopting this perspective on parameter uncertainty means far fewer AAA-rated securities can be issued and therefore present fewer opportunities to offer investors attractive yields. Investors need to recognize the fundamental difference between single name and structured securities in terms of exposure to systematic risk. Unlike traditional corporate bonds, whose fortunes are primarily driven by firm-specific considerations, the performance of securities created by tranching large asset pools is strongly affected by the performance of the economy as a whole. Senior structured finance claims have the features of economic catastrophe bonds, in that they are designed to default only in the event of extreme economic duress. Because credit ratings do not indicate conditions in which default is likely to happen, they do not capture exposure to systematic risks. The lack of consideration for certain types of exposure reduces the usefulness of ratings, no matter how precise they are made to be. Closed for comment; 0 Comments.

Economic Catastrophe Bonds

Pooling economic assets into large portfolios and tranching them into sequential cash-flow claims has become a big business, generating record profits for both the Wall Street originators and the agencies that rate these securities. This paper by business economics doctoral student Jakub Jurek and HBS professors Joshua Coval and Erik Stafford investigates the pricing and risks of instruments created as a result of recent structured finance activities. It demonstrates that senior collateralized debt obligation (CDO) tranches have significantly different systematic risk exposures than their credit rating-matched, single-name counterparts, and should therefore command different risk premia. Key concepts include: Investors in senior CDO tranches are grossly undercompensated for the highly systematic nature of the risks they bear. An investor willing to assume the economic risks inherent in senior CDO tranches can, with equivalent economic exposure, earn roughly 3 times more compensation by writing out-of-the-money put spreads on the market. Credit rating agencies do not provide customers with adequate information for pricing. They are willing to certify senior CDO tranches as "safe" when, from an asset pricing perspective, they are quite the opposite. Closed for comment; 0 Comments.