Abstract
In this paper, we present a dynamic risk model that can assess the stochastic credit quality of senior tranches of collateralized mortgage obligations (CMO) while supported by any number of junior bond classes. We design the model to be universal and to embed common hazards and retreats within the U.S. housing market. This deployment assists us in resolving real problems when gauging the dynamic creditworthiness of CMOs’ senior bond tranches. Resulting from our subsequent theoretical simulations, we discover the boundaries of these structured financial instruments when exposed to relatively modest probabilities of a broad economic crisis. We demonstrate that despite their diverse supportive structures, CMOs are not as protective as originally thought by many investors when a widespread housing calamity progresses.
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