62 Pages Posted: 21 Nov 2014 Last revised: 21 May 2016
Date Written: May 20, 2016
This paper proposes several frameworks to estimate the appropriate default correlations for structured products, each of which jointly considers the role of co-movements in modeled risk characteristics and un-modeled systematic risk, or 'frailty'. We contrast our estimates with credit rating agencies' default correlation assumptions, which were only 0.01 for CLOs pre-crisis and have increased to 0.03 post-crisis. In contrast, the joint consideration of observable risk factors and frailty leads to substantially higher estimates of 0.12. We show that this translates into CLOs with credit risk understated by more than 22%, suggesting caution for the post-crisis structured finance market.
Keywords: Credit Ratings, Financial Crises, Structured Finance, Default Correlations
JEL Classification: G14, G24, G28, G32
Suggested Citation: Suggested Citation
Griffin, John M. and Nickerson, Jordan, Debt Correlations in the Wake of the Financial Crisis: What are Appropriate Default Correlations for Structured Products? (May 20, 2016). Available at SSRN: https://ssrn.com/abstract=2528180 or http://dx.doi.org/10.2139/ssrn.2528180