CDOs and Systematic Risk: Why Bond Ratings are Inadequate

Posted: 7 Jul 2009

See all articles by Jan Pieter Krahnen

Jan Pieter Krahnen

Goethe University Frankfurt

Christian Wilde

Goethe University Frankfurt - Department of Finance

Date Written: June 24, 2009

Abstract

This paper analyzes the risk properties of typical asset-backed securities (ABS), like CDOs or MBS, relying on a model with both macroeconomic and idiosyncratic components. The examined properties include expected loss, loss given default, and macro factor dependencies. Using a two-dimensional loss decomposition as a new metric, the risk properties of individual ABS tranches can directly be compared to those of corporate bonds, within and across rating classes. By applying Monte Carlo Simulation, we find that the risk properties of ABS differ significantly and systematically from those of straight bonds with the same rating. In particular, loss given default, the sensitivities to macroeconomic risk, and model risk differ greatly between instruments. Our findings have implications for understanding the credit crisis and for policy making. On an economic level, our analysis suggests a new explanation for the observed rating inflation in structured finance markets during the pre-crisis period 2004-2007. On a policy level, our findings call for a termination of the 'one-size-fits-all' approach to the rating methodology for fixed income instruments, requiring an own rating methodology for structured finance instruments.

Keywords: credit risk, risk transfer, systematic risk

JEL Classification: G21, G28

Suggested Citation

Krahnen, Jan Pieter and Wilde, Christian, CDOs and Systematic Risk: Why Bond Ratings are Inadequate (June 24, 2009). CFS Working Paper No. 2009/11, Available at SSRN: https://ssrn.com/abstract=1428793

Jan Pieter Krahnen (Contact Author)

Goethe University Frankfurt ( email )

Gr├╝neburgplatz 1
Frankfurt am Main, 60323
Germany

Christian Wilde

Goethe University Frankfurt - Department of Finance ( email )

House of Finance
Grueneburgplatz 1
Frankfurt am Main, Hessen 60323
Germany

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