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Default Risk Sharing Between Banks and Markets: The Contribution of Collateralized Debt Obligations

Posted: 17 Feb 2005  

Guenter Franke

University of Konstanz - Department of Economics

Jan Pieter Krahnen

Faculty of Economics and Business Administration; Goethe University Frankfurt - Research Center SAFE; Center for Financial Studies (CFS); Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 2 versions of this paper

Date Written: February 15, 2005

Abstract

This paper contributes to the economics of financial institutions risk management by exploring how loan securitization affects their default risk, their systematic risk, and their stock prices. In a typical CDO transaction a bank retains through a first loss piece a very high proportion of the expected default losses, and transfers only the extreme losses to other market participants. The size of the first loss piece is largely driven by the average default probability of the securitized assets. If the bank sells loans in a true sale transaction, it may use the proceeds to to expand its loan business, thereby incurring more systematic risk. We find an increase of the banks' betas, but no significant stock price effect around the announcement of a CDO issue. Our results suggest a role for supervisory requirements in stabilizing the financial system, related to transparency of tranche allocation, and to regulatory treatment of senior tranches.

JEL Classification: D82, G21, D74

Suggested Citation

Franke, Guenter and Krahnen, Jan Pieter, Default Risk Sharing Between Banks and Markets: The Contribution of Collateralized Debt Obligations (February 15, 2005). CFS Working Paper No. 2005/06. Available at SSRN: https://ssrn.com/abstract=668264 or http://dx.doi.org/10.2139/ssrn.668264

Guenter Franke

University of Konstanz - Department of Economics ( email )

Fach 147
Konstanz, 78457
Germany
+49 7531 88 2545 (Phone)
+49 7531 88 3559 (Fax)

Jan Pieter Krahnen (Contact Author)

Faculty of Economics and Business Administration ( email )

Theodor-W.-Adorno-Platz 3
Frankfurt am Main, 60629
Germany
+49 69 798 33699 (Phone)
+49 69 798 33901 (Fax)

Goethe University Frankfurt - Research Center SAFE ( email )

(http://www.safe-frankfurt.de)
Theodor-W.-Adorno-Platz 3
Frankfurt am Main, 60629
Germany
+49 69 798 30080 (Phone)
+49 69 798 30077 (Fax)

Center for Financial Studies (CFS) ( email )

Theodor-W.-Adorno-Platz 3
Frankfurt am Main, 60629
Germany
+49 69 798 30050 (Phone)
+49 69 798 30077 (Fax)

Centre for Economic Policy Research (CEPR)

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

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