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Title:CDOs and systematic risk: Why bond ratings are inadequate PDF Logo
Authors:Krahnen, Jan Pieter
Wilde, Christian
Issue Date:2009
Series/Report no.:Working paper series // Johann-Wolfgang-Goethe-Universität Frankfurt am Main, Fachbereich Wirtschaftswissenschaften Finance & accounting 203
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.
Subjects:credit risk
risk transfer
systematic risk
JEL:G21
G28
Document Type:Working Paper
Appears in Collections:Working Paper Series: Finance and Accounting, Universität Frankfurt a. M.

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