Correlated Collateral

Abstract

The prioritized cash flow rules that govern structured finance essentially guarantee that senior tranches will only default in the worst states of the world. In this paper we present empirical evidence which suggests that the impact of economic catastrophe on a structured finance instrument also depends critically on the degree of correlation in the underlying collateral generating the cashflows. Subprime mortgage-backed securities with highly geographically concentrated mortgage collateral (our proxy for correlation) experienced substantially higher deal-level default rates and more significant credit rating downgrades during the financial crisis. Not all deals had geographically concentrated collateral. In fact, we document considerable cross-sectional variation. Collateral concentration did not appear to be priced in the subprime bond market.