Structured Credit Products Research Articles

Exploring Dynamic Default Dependence

Characterizing the dependence between companies’ defaults is a central problem in the credit risk literature, and the dependence structure is a first order determinant of the value of credit portfolios and structured credit products such as collateralized debt obligations (CDO), as well as the relative values of CDO tranches. We compare correlation measures implied by CDO prices with time-varying correlations implied by equity returns and CDS spreads. We use flexible dynamic equicorrelation techniques introduced by Engle and Kelly (2008) to capture time variation in CDS-implied and equity return-implied correlations. We perform this analysis using North American firms from the CDX index, as well as European firms from the iTraxx index. All correlation time series are highly time-varying and persistent, and correlations extracted from CDSs and CDOs increased significantly in European and North American markets during the turbulent second half of 2007. Interestingly, we find that the correlation time-series implied by CDO prices co-moves very strongly with the correlation time-series extracted from CDS spreads, but somewhat less strongly with the correlations between equity returns. These findings suggest that the cross-sectional dependence in these complex structured products is fairly well measured. However, changes in CDO prices may be due to changes in correlation, and more sophisticated models with time-varying correlations are thus needed to value CDOs.

Regulating Credit Rating Agencies in the European Union: A Critical First Assessment of the European Commission Proposal

In the wake of the ongoing global financial crisis, recently the European Commission has published a proposal for a European Parliament and Council Regulation on Credit Rating Agencies. With this proposal the European Union aims at addressing calls for more regulation of the (global) financial markets and overall improvements in the rating process of Credit Rating Agencies. According to some analysts, such as the Financial Stability Forum, poor credit assessments of complex structured credit products by Credit rating Agencies contributed to both the build up and the unfolding of the financial crisis. The authors offer a first critical comparative examination of the proposed Regulation against the background of the current regime under the non-binding IOSCO Code of Conduct for Credit Rating Agencies. In doing so, answers are sought to the question, whether and to what extent the introduction of the envisaged regulatory framework will result in a more effective and efficient oversight over the activities of Credit Rating Agencies in the European Union. A certain degree of scepticism may be called for, as the proposed Regulation falls short of addressing some important shortcomings of the present regulatory framework, while the value added of the proposed regulatory framework may not necessarily outweigh its risks.

Measuring and Modeling Default Dependence: Evidence from CDO, CDS and Equity Data

Characterizing the dependence between companies' defaults is a central problem in the credit risk literature. This dependence structure is a first order determinant of the relative values of structured credit products such as collateralized debt obligations (CDO). We present a number of stylized facts useful in guiding the modeling of default dependence. We systematically compare correlation measures implied from three different markets: base correlations implied by CDO prices, correlations implied by equity returns, and correlations estimated from default intensities implied by CDS prices. We use flexible dynamic equicorrelation techniques introduced by Engle and Kelly (2007) to capture time variation in CDS-implied and equity return-implied correlations while base correlations are obtained using the Gaussian copula. We perform this analysis using American data, the components of the CDX index, as well as European data, the components of the iTraxx index. For each index, there is substantial co-movement between the three correlation time-series. All correlations are highly time-varying and persistent. European and North American correlation series display considerable co-movement. Correlations across both markets increased significantly during the turbulent second half of 2007.

Resolutions of weak institutions

The present financial crisis may be added to a growing list of episodes worldwide in which financial sector problems have become systemic in nature. Many OECD countries have been affected, either directly or through the transmission of problems cross-border. Most financial crises share a number of common elements.For instance, financial innovation has often played a role in distress episodes, in many cases, having much to do with their idiosyncratic aspects. For example, structured credit products and the latest incarnation of the originate-and-distribute model of intermediation have been at the epicentre of the current crisis. It differs from other crisis episodes in having a sub-component of the residential mortgage sector as its trigger, while previous crises have more often been prompted by problems in the commercial mortgage market and with corporate clients.

Regulating Credit Ratings in the European Union: A Critical First Assessment of Regulation 1060/2009 on Credit Rating Agencies

In the wake of the global financial crisis, the European Parliament and Council Regulation 1060/2009 on Credit Rating Agencies has recently been published in the Official Journal of the European Union. With this Regulation the European Union takes a first step in addressing calls for a better regulation of the (global) financial markets including, among other things, overall improvements in the rating process of Credit Rating Agencies. According to some analysts, such as the Financial Stability Forum, poor credit assessments of complex structured credit products by Credit rating Agencies contributed to both the build-up and the unfolding of the financial crisis. This contribution offers a first critical comparative examination of Regulation 1060/2009 against the background of the previously applicable regime under the non-binding IOSCO Code of Conduct for Credit Rating Agencies. In doing so, answers are sought to the question whether and to what extent the introduction of the envisaged regulatory framework has the potential to result in a more effective and efficient oversight over the activities of Credit Rating Agencies in the European Union. A certain degree of scepticism may be called for, as the Regulation fails to address some important shortcomings of the present system, while the value added of the regulatory framework may not necessarily outweigh its risks. In this context also the implications for this Regulation of the recent proposals of the European Commission to create a European System of Financial Supervisors as part of an effort to strengthen financial supervision in Europe are addressed.

Robust Valuation of Synthetic CDOs

The recent events, notably the subprime crises, have shed light on the valuation problems of structured credit products. The standard model, namely the Large Pool Homogeneous Gaussian copula model, does not fit well with market data. Indeed, if the implied default probability of an underlying pool of credit risks is calibrated for different CDO tranches, it is typically a non-linear function of those tranche attachment points. This fact is known as the correlation smile. This is not only a source of problems from the theoretical point of view, but also from the practical point of view, as there might exist a few implied correlations for the same tranche. Practitioners developed a pricing approach known base correlation. The latter gets rid of the problem of multiple implied correlations. The advantage of base correlations is that the relationship between prices and correlation is monotonic. Still, all these approaches are unsatisfactory from a theoretical point of view. We argue that the main issue is misspecification and that the decision maker that values CDOs faces parametric uncertainty. Given the uncertainty concerning correlation estimation this is quite a realistic assumption. The kind of uncertainty faced by investors can be treated within the robust decision making framework. We use that frame work to show how different CDO tranches can be valued and provide a rational explanation of the correlation smile.

The Two-Tranche Method of Estimating CDO Recovery Rates

Similarly rated tranches are not created equal. Among other things, some tranches have better recovery potential than others. Investors who rely on rating agency look-up tables to estimate recovery rates for structured credit products may over-or underestimate recovery values. This is particularly true for managers of CDO-Squared or ABS CDO transactions. We propose the Two Tranche Method (TTM) as a way for investors to quickly estimate CDO tranche recovery rates.

The Evolution of the CDO Squared

The structured credit products market has seen a rapid proliferation of new products that fit under the rubric of a “CDO Squared” (or “CDO2”). Most underwriters now offer several different forms of this product, and many of the leading fixed-income investment managers are managing several portfolios of this type. But as the product has evolved from a simple, well-understood structured offering to a series of ever more complex and varied structured products, there has ceased to be a clear understanding of this product, particularly among investors. This article offers a methodology for characterizing the diverse products generally known as CDO2 into four basic paradigms, cash CDO2 formed to invest in CDO debt, cash CDO2 formed to invest in CDO equity, synthetic CDO2 referencing CDO securities, and synthetic CDO2 referencing single-tranche CDOs.

Optimizing Selection of Credit Portfolios

Our ability today to construct a great number of portfolios that all satisfy the same set of static collateralized debt obligation (CDO) investment guideline, can potentially introduce credit hot spots that will not be detected by traditional rating agency measures. As more and more CDO market participants recognize these risks, they are turning to market-based measures such as bond and loan prices and debt-equity models to parse credit aberrations in credit portfolios and detect selection biases. Various market-based information and models will be helpful in CDO and cash-based portfolio selection. New asset selection tools for structured credit products allow investors to benchmark the performance of seasoned CDO tranches.

Active loan portfolio management through the use of credit derivatives

The purpose of this article, which is based on a recent presentation by Paul Van der Maas, is to give the reader a brief overview of common credit derivatives, the size and scope of their markets and their role in structured credit products. The case study uses as a reference a current deal that Bank of America has structured using credit derivatives.