The Economics of Structured Finance

by Joshua D. Coval, Jakub Jurek & Erik Stafford

Overview — 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.

Author Abstract

This paper investigates the spectacular rise and fall of structured finance. The essence of structured finance activities is the pooling of economic assets like loans, bonds, and mortgages, and the subsequent issuance of a prioritized capital structure of claims, known as tranches, against these collateral pools. As a result of the prioritization scheme used in structuring claims, many of the manufactured tranches are far safer than the average asset in the underlying pool. This ability of structured finance to repackage risks and to create "safe" assets from otherwise risky collateral led to a dramatic expansion in the issuance of structured securities, most of which were viewed by investors to be virtually risk-free and certified as such by the rating agencies. At the core of the recent financial market crisis has been the discovery that these securities are actually far riskier than originally advertised. We examine how the process of securitization allowed trillions of dollars of risky assets to be transformed into securities that were widely considered to be safe. We highlight two features of structured finance products - the extreme fragility of their ratings to modest imprecision in evaluating underlying risks, and their exposure to systematic risks - that go a long way in explaining the spectacular rise and fall of structured finance. We 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.