Coval: Economics of Structured Finance

Question 1

Structured finance

Answer 1

Pooling economic assets and issuing prioritized structure of claims against these pools

Question 2

Overcollateralization of junior tranche

Answer 2

Plays role in determining credit rating of more senior tranche

Question 3

Junior tranche vs. senior tranche

Answer 3

Jr: Risky/low prices/high promised returns

Sr: Relatively safe/high prices/low returns

Question 4

CDO²

Answer 4

CDO created from the tranches of other CDOs

Question 5

Determining ability to create tranches

Answer 5

Extent to which defaults are correlated across underlying assets; lower default correlation, more improbable assets with default simultaneously (safer senior tranche)

Question 6

Challenge of rating structured finance assets

Answer 6

With single-name assets, rating agencies can ignore correlations

Effect of imprecise estimates of default likelihoods magnified

CDO² have even more sensitivity and rating could change easily

Question 7

Sensitivity of CDO to changes in default correlation

Answer 7

Question 8

Sensitivity of CDO² to changes in default correlation

Answer 8

Question 9

Sensitivity of CDO to changes in default probability

Answer 9

Question 10

Sensitivity of CDO² to changes in default probability

Answer 10

Question 11

Rating modifier to structured finance instruments

Answer 11

.SF, due to plausible uncertainty of estimates of underlying model parameters

Question 12

Examples of deteriorating quality of mortgages

Answer 12

1. Ratio of mortgage values to home prices increased
2. Increased use of second liens
3. Increase issuance without documentation

Question 13

Issue with rates of return and tranches

Answer 13

Senior tranches bear significant systematic risk and are undercompensated for such risk (CAPM)

Yields appear attractive relative to securities with similar credit ratings, but well below return

Question 14

Characteristics of CMOs biased against investors

Answer 14

1. High probability of default (lower credit borrowers)
2. Lower recovery values (sell now)
3. High level of default correlation (geography)
4. Errors of estimates magnified, especially in CDO²

Question 15

Blame for investors with CDOs

Answer 15

Did not question robustness

Assumed it would go on forever given rapid growth of market and few defaults

Question 16

Blame for rating agencies with CDOs

Answer 16

1. Rating inappropriate, brought investors significant interest
2. Significant mistakes in estimates (did not appreciate impact)
3. Conflict of interest (issuer pays for rating – disproved)

Question 17

Blame for banks with CDOs

Answer 17

1. Collected fees, making money on side
2. Dealers and investors in market
3. Short-run payoffs too compelling to ignore, even if not long-term collapse
4. Held senior tranches, on the hook for 100s of billions

Question 18

Three sensitive assumptions of CDOs

Answer 18

1. Default probability and recovery value
2. Correlation of defaults
3. Relation between payoffs and economic states investors care about most

Question 19

Coval’s solution for fixing CDOs

Answer 19

Bayesian approach that explicitly acknowledges uncertainty of parameters

However, will result in far fewer AAAs and fewer attractive options