CDOs and the financial crisis: Credit ratings and fair premia

We study risk and return characteristics of CDOs using the market standard models. We find that fair spreads on CDO tranches are much higher than fair spreads on similarly-rated corporate bonds. Our results imply that credit ratings are not sufficient for pricing, which is surprising given their central role in structured finance markets. This illustrates limitations of the rating methodologies that are solely based on real-world default probabilities or expected losses and do not capture risk premia. We also demonstrate that CDO tranches have large exposure to systematic risk and thus their ratings and prices are likely to decline substantially when credit conditions deteriorate.     

Tranching and Rating

In this paper we analyse the source and magnitude of marketing gains from selling structured debt securities at yields that reflect only their credit ratings, or specifically at yields on equivalently rated corporate bonds. We distinguish between credit ratings that are based on probabilities of default and ratings that are based on expected default losses. We show that subdividing a bond issued against given collateral into subordinated tranches can yield significant profits under the hypothesised pricing system. Increasing the systematic risk or reducing the total risk of the bond collateral increases the profits further. The marketing gain is generally increasing in the number of tranches and decreasing in the rating of the lowest rated tranche.     

Credit ratings and structured finance

The poor performance of credit ratings of structured finance products in the financial crisis has prompted investigation into the role of credit rating agencies (CRAs) in designing and marketing these products. We analyze a two-period reputation model in which a CRA both designs and rates securities that are sold both to investors who are constrained to purchase highly rated securities and investors who are unconstrained. Assets are pooled and senior and junior tranches are issued with a waterfall structure. When the rating constraint is lax, the CRA will include only risky assets in the securitization pool, serving both types of investors without any rating inflation. Rating inflation is decreasing in the tightness of the rating constraint locally. But rating inflation may be non-monotonic in the rating constraint globally, with no rating inflation when the constraint is lax or tight.     

The systematic risk of corporate bonds: default risk,term risk,and index choice

In this paper, we empirically examine the systematic risk of corporate bonds in the Euro area. Based on a unique sample of 784 bonds from 1999 to 2010, we show that the systematic risk of constructed bond portfolios and individual bonds—measured against three different market indices—depends on credit quality, term risk, and index choice. A significant increase in systematic risk for lower-rated bonds is observed following the start of the financial crisis. In multi-factor models, bond portfolios load significantly on default and term risk, which are included as additional factors. Conducting Fama and MacBeth cross-sectional tests, we find that default and term risk are priced with economically relevant premiums that range from 0.35 to 0.62 % per month. Our results are robust to the inclusion of characteristics such as rating and time to maturity.     

Ratings based capital adequacy for securitizations

This paper develops a framework to measure the exposure to systematic risk for pools of asset securitizations and measures empirically whether current ratings-based rules for regulatory capital of securitizations under Basel II and Basel III reflect this exposure. The analysis is based on a comprehensive US dataset on asset securitizations for the time period between 2000 and 2008. We find that the shortfall of regulatory capital during the Global Financial Crisis is strongly related to ratings. In particular, we empirically show that insufficient capital is allocated to tranches with the highest rating. These tranches account for the greatest part of the total issuance volumes. Furthermore, this paper is the first to calibrate risk weights which account for systematic risk and provide sufficient capital buffers to cover the exposure during similar economic downturns. These policy-relevant findings suggest a re-calibration of RBA risk weights and may contribute to the current efforts by the Basel Committee on Banking Supervision and others to re-establish sustainable securitization markets and to improve the stability of the financial system.     

Did going public impair Moody׳s credit ratings?

We investigate a prominent allegation in congressional hearings that Moody?s loosened its rating standards to chase revenue after it went public in 2000. Consistent with this allegation, Moody?s ratings for both corporate bonds and structured finance products are significantly more favorable to issuers, relative to S&P?s, after Moody?s IPO. Moreover, Moody?s ratings are more favorable for clients subject to greater conflict of interest. There is little evidence that Moody?s higher ratings, post-IPO, are more informative, measured as expected default frequencies (EDFs) or as the probability of default. Our findings inform the debate on whether financial gatekeepers should be publicly traded.     

Securitization bubbles: Structured finance with disagreement about default risk

An additional reason for the structured finance boom of the 2000s may have been disagreement about default risk of collateral assets. When risk-neutral investors disagree about average default probabilities, structuring collateral cash flow raises prices by concentrating optimists’ demand on risky tranches. With disagreement about default correlation, low-correlation investors believe in diversification and pay high prices for senior tranches they deem riskless. High-correlation investors value junior tranches they expect to pay whenever aggregate conditions are good. Risk aversion and short selling through credit default swaps reduce the prices of both pass-through and structured securitizations but may increase the return to tranching.     

Pricing structured products with economic covariates

We introduce a top-down no-arbitrage model for pricing structured products. Losses are described by Cox processes whose intensities depend on economic variables. The model provides economic insight into the impact of structured products on financial institutions’ risk exposure and systemic risk. We estimate the model using CDO data and find that spreads decrease with higher interest rates and increase with volatility and leverage. Volatility is the primary determinant of variation in tranche spreads. Leverage and interest rates are more closely associated with rare credit events. Model-implied risk premiums and the probabilities of tranche losses increase substantially during the financial crisis.     

Competition in the credit rating Industry: Benefits for investors and issuers

We empirically investigate the benefits of multiple ratings not only at issuance of debt instruments but also during the subsequent monitoring phase. Using a record of monthly credit rating migration data on all U.S. residential mortgage-backed securities rated by Standard & Poor's, Moody's, and Fitch between 1985 and 2012 (154,600 tranches), our results provide empirical evidence that rating agencies put more effort in rating and outlook revisions when tranches have assigned multiple ratings. Furthermore, we see that in the case of multiple ratings, agencies do a better job in discriminating tranches with respect to default risk. On the downside, we observe a shift in collateral towards senior tranches and incentives for issuers to engage in rating shopping activities, but find no evidence that rating agencies exploit such behavior to attract more rating business. Our results contribute to the literature on information production of credit ratings and extend the perspective to the monitoring period after issuance.     

债务抵押凭证（CDO）的风险与信用评级研究

债务抵押凭证（CDO）是金融市场重要的风险转移工具，具有信用级别高、收益水平高的特征，其市场规模扩展迅速。但这种金融创新产品因较复杂的基础资产和分层结构，产生出异于传统公司债券的风险特征。很多投资者没有真正了解其潜在风险，且信用评级质量不佳，致使CDO投资者在次贷危机中遭受严重损失甚至破产。因此有必要深入了解CDO所具有的风险特征和CDO产品信用评级的一般方法，纠正现有评级方法的不足，分析其对次贷危机的影响。     

Divergence in credit ratings

During the recent credit crisis credit rating agencies (CRAs) became increasingly lax in their rating of structured products, yet increasingly stringent in their rating of corporate bonds. We examine a model in which a CRA operates in both the market for structured products and for corporate debt, and shares a common reputation across the two markets. We find that, as a CRA’s reputation becomes good enough, it can be optimal for it to inflate its ratings with probability one in the structured products market, but inflate its ratings with probability zero in the corporate bond market.     

Financial statement comparability and credit risk

Prior research shows that firms’ financial statement comparability improves the accuracy of market participants’ valuation judgments and thus may reduce firms’ costs of capital. Distinct from prior research focusing on the equity market, we develop measures of comparability relevant to debt market participants based on the within-industry variability of Moody’s adjustments to reported accounting numbers for the purposes of credit rating. We examine two sets of adjustments: (1) to the interest coverage ratio and (2) to non-recurring income items. We validate these comparability measures by providing evidence that greater comparability is associated with lower frequency and magnitude of split ratings by credit rating agencies. We predict and find that greater comparability is associated with (1) lower estimated bid-ask spreads for traded bonds, (2) lower credit spreads for both bonds and five-year credit default swaps, and (3) a steeper one- to five-year credit default swap term structure. Our results are consistent with financial statement comparability reducing debt market participants’ uncertainty about and pricing of firms’ credit risk.     

Neglected Risk in Financial Innovation: Evidence from Structured Product Counterparty Exposure

We investigate the compensation of counterparty exposure in the prices of structured products. Our analysis reveals that product issuers did not compensate retail investors for counterparty exposure before the Lehman default. Post-Lehman, retail prices have no longer neglected this risk. We also measure retail investor attention towards issuer credit risk. For a given level of issuer credit risk, counterparty exposure is compensated more when attention is higher. Furthermore, issuers tend to construct products with larger counterparty exposure. Overall, our results shed light on the conditions under which financial engineering generates neglected risk.     

Default Clustering Risks in Commercial Mortgage-Backed Securities

This paper proposes an intensity-based pricing model with default dependence structure for CMBS bonds. Three features are incorporated into the proposed model. First, default is a Poisson jump process defined by a function of mortgage rating information. Second, property risks are modeled using a high dimensional Brownian motion process that captures both systematic risk and idiosyncratic risk in property value. Third, default dependence structure is built into the extended model. Based on a set of input parameters, we simulate various pricing effects on a hypothetical CMBS using the proposed model structure. The results of the base-line intensity model show that yield spreads on CMBS bonds increase in the recovery rate, but decreases in the hazard rate. Security structured with smaller subordination tranche exposes CMBS bonds to higher default risks. The model predicts that default clustering increases required yield spreads of CMBS bonds. At a 70% recovery rate and a 3% default hazard rate, yield spreads of Junior bonds are expected to increase by 169 basis points when counterparty risks increase by 50%. The results highlight the importance of clustering risks associated with counterparty default when valuing CMBS bonds.     

欧洲高收益债券市场违约风险监管研究

多年以来,欧洲一直是仅次于美国的世界第二大高收益债券市场。除了债券自身信用评级水平之外,欧洲高收益债券违约率的高低与市场监管力度以及宏观金融经济运行状况密切相关。欧洲监管当局把对高收益债券市场的监管重点放在:规范市场信息披露及信用评级标准和行为、保护投资者权益、保持交易行为的规范性和跨国界市场交易衔接处理等方面,这些监管策略的实施对控制市场违约风险起到了积极的作用。欧洲的监管经验对于今后我国高收益债券市场的尝试性推出也极具借鉴意义。     

Valuation of collateralized debt obligations with hierarchical Archimedean copulae

Modelling portfolio credit risk is one of the crucial challenges faced by financial services industry in the last few years. We propose the valuation model of collateralized debt obligations (CDO) based on hierarchical Archimedean copulae (HAC) with up to three parameters, with default intensities calibrated to market data and with random loss given defaults that are correlated with default times. The methods presented are used to reproduce the spreads of the iTraxx Europe tranches. Our approach describes the market prices better than the standard pricing procedure based on the Gaussian distribution. We also obtain a flat correlation smile across tranches thereby solving the implied correlation puzzle.     

Extreme Events and the Copula Pricing of Commercial Mortgage-Backed Securities

Commercial mortgage-backed securities (CMBS), as a portfolio-based financial product, have gained great popularity in financial markets. This paper extends Childs, Ott and Riddiough’s (J Financ Quant Anal, 31(4), 581–603, 1996) model by proposing a copula-based methodology for pricing CMBS bonds. Default on underlying commercial mortgages within a pool is a crucial risk associated with CMBS transactions. Two important issues associated with such default—extreme events and default dependencies among the mortgages—have been identified to play crucial roles in determining credit risk in the pooled commercial mortgage portfolios. This article pays particular attention to these two issues in pricing CMBS bonds. Our results show the usefulness and potential of copula-based models in pricing CMBS bonds, and the ability of such models to correctly price CMBS tranches of different seniorities. It is also important to sufficiently consider complex default dependence structure and the likelihood of extreme events occurring in pricing various CMBS bonds.     

The alchemy of CDO credit ratings

Collateralized loan obligations (CLOs) were one of the largest and fastest growing segments of the structured finance market, fueling the 2003-2007 boom in syndicated loans and leveraged buyouts. The credit crisis brought CLO issuance to a halt, and as a result the leveraged loan market dried up. Similar to other structured finance products, investors in CLOs rely heavily on credit rating provided by the rating agencies, yet little is known about CLO rating practices. This paper attempts to fill the gap. Using novel hand-collected data on 3912 tranches of collateralized loan obligations we document the rating practices of CLOs and analyze their structures.     

A comparative analysis of ex ante credit spreads: Structured finance versus straight debt finance

This paper examines the pricing of structured finance (SF) – asset-backed securities (ABS), mortgage-backed securities (MBS), and collateralized debt obligations (CDO) – and straight debt finance transactions. Using a cross-section of 24,525 European bonds issued by financial and nonfinancial firms in the 2000–2016 period, we show that although ratings are the most important pricing determinant for SF and corporate bonds (CB) at issuance, investors rely on other contractual, macroeconomic, and firms’ characteristics beyond these ratings. We find that CDO tranches have, on average, higher credit spreads than similarly rated CB, while investors are not compensated for facing higher systematic risk components in relation to investment-grade ABS and MBS. Our results also support the hypothesis of SF transactions as mechanisms of reducing funding costs: SF transactions’ weighted average spread is lower than that of comparable CB and originating firms’ creditworthiness does not deteriorate when compared to a sample of matched firms.     

关于或有可转换债券的研究

次贷金融危机后,或有可转换债券作为解决＂太大而不能倒闭＂的一种方案以及金融机构的自救手段而广受热议,并得到许多监管机构的推崇。文章在对或有可转换债券产品及其功能进行深入分析后,发现其仍面临着诸如监管风险、低评级风险以及技术性风险等制约因素。鉴于或有可转换债券在危机期间显示出的对企业强大的救助功效以及防范危机进一步蔓延的能力,其发展前景仍值得期待,文章最后对或有可转换债券未来的发展方向进行了展望。