Structured Finance Securities Research Articles

Commentary: Credit Rating Failures in the Aftermath of the Mortgage Meltdown

Credit ratings from the major rating agencies failed to signal the true risk content of residential mortgage-backed securities (RMBS), collateralized debt obligations (CDOs), and commercial mortgage-backed securities (CMBS) issued from 2005 through 2007. This article compares the failures across rating agencies and asset classes, using data filed by the rating agencies with the Securities and Exchange Commission (SEC). The data confirm the terrible performance of RMBS ratings. The likely causes include a combination of the breakdown of mortgage industry lending practices and the concurrent deterioration of rating agency practices. The data show that CDO ratings perform somewhat better than RMBS ratings. That result is perhaps surprising and likely reflects the confounding effects of the SEC’s definitions of its reporting categories. The data also show bad performance for CMBS ratings although the underlying causes differ from those driving the results for RMBS and CDOs. Moreover, the data show high levels of rating withdrawals across all asset classes, raising the question of possible underreporting of defaults. <b>Key Findings</b> ▪ Rating agency data reported to the SEC confirm the terrible performance of RMBS ratings, with triple-A-rated RMBS displaying 10-year default rates of 30% to 35% as of year-end 2017. The likely causes include a combination of the breakdown of mortgage industry lending and securitization practices and the concurrent deterioration of rating agency practices. ▪ The data show that CDO ratings performed better than RMBS ratings, likely because the data include ratings for many synthetic corporate CDOs. Other studies indicate that performance is significantly worse for CDOs backed by structured finance assets. ▪ CMBS ratings also performed poorly. Although CMBS rated triple-A displayed 10-year default rates of only 2% to 3%, those rated double-A had default rates of 12% to 19% while single-A-rated CMBS default rates were 23% to 32%. ▪ The data document high levels of unexplained rating withdrawals on structured finance securities. The effect of such withdrawals may be to artificially depress the reported default rates.

Final Demand for Structured Finance Securities

Structured finance boomed during the run-up to the 2008 financial crisis. Highly rated, structured securities offered higher yield than other similarly rated bonds because of their concentration of systematic risk, but regulatory capital requirements did not account for this risk. As a result, regulated entities facing capital constraints had an incentive to invest in them. We show that life insurance companies exposed to unrealized losses from low interest rates in the early 2000s increased their holdings of highly rated securitized assets, consistent with regulatory arbitrage distorting the demand to hold these assets. This paper was accepted by Amit Seru, finance.

Complexity in Structured Finance and Difficulties Faced by Market Participants-A Critical Assessment of the Role of the Complexity in Financial Crisis

The global financial crisis has been blamed on the part of the increasing complexity in the financial system which is one of the key developments in modern finance. Due to greater globalization and the integration of financial institutions and markets, they have become more interconnected and more fragile in the financial system. A significant proportion of the complex nature of the financial system results from the development of complex structured finance securities. The aim of this study is to investigate the remarkable rise and fall of structured finance by emphasizing the role of complexity. This study first examines the ways in which structured finance become more complicated over the last two decades. Complexity in structured finance arises from the pooling of assets, the detailed deal-specific structuring and documentations necessitated by tranching and the involvement of third parties. Besides, we have defined the term ‘complexity’ more narrowly to provide a better understanding of the essence of the complexity. Further, this study examines the motive for the financial institutions to issue more complex structured finance securities and finds that the increased complexity has been used as a mechanism to distract market participants. Finally, the complex structure of securities along with the perverse incentives and gluttonous behaviour of the market participants have undoubtedly impelled financial market towards more complex condition and ultimately thrust towards the collapse.

Overcoming Inefficiencies in the Pricing of Structured Finance Instruments

Unlike the market for heavily traded stocks, there is much less transparency into the pricing of fixed-income securities, with particular inefficiencies in the market for structured finance securities. For reasons described in the article, companies and funds can yield significant advantages by inflating the value of their assets. Meanwhile, financial market regulators, attuned to the incentive structure, have been aggressive in investigating the potential for “mis-markings.” Wide discrepancies can be seen between the valuations used by different companies and, at times, even between the levels shown for the same security held in different portfolios at a single company. Several of these discrepancies can easily—and innocently—be explained in the structured finance markets, due to various inefficiencies. This article explores some of the reasons the structured finance market is prone to such inefficiencies and is particularly vulnerable to them during a stressed market environment—and provides suggestions for possible improvements. <b>TOPICS:</b>Fixed income and structured finance, information providers/credit ratings

Exploring rating shopping for european triple a senior structured finance securities

In much of the research with respect to the use of credit ratings, the notion of rating shopping features prominently. One form of rating shopping predicts that investors price the risk that arises when securities have fewer than three ratings. Inconsistent with what rating shopping would predict, our study shows that for the largest European structured finance market, the triple A sector of the senior European residential mortgage-backed market prior to 2007, investors demanded a premium for more ratings. Moreover, we find that certain characteristics unique to structured finance securities that investors perceive as complex, determine whether issuers opt for a higher number of triple A ratings.

Inflated Ratings on Pre-Crisis CDOs: A Deeper Look

Methodologies for analyzing and rating collateralized debt obligations (CDOs) backed by structured finance securities (SF-CDOs) were significantly flawed before the 2008 financial crisis. Two key issues were model risk and the absence of calibration to historical benchmarks. Although financial literature highlighted model risk as a potential problem starting in the mid-1990s, market participants— including the rating agencies—failed to properly address the issue. That partly explains why SF-CDOs that performed horribly during and after the financial crisis received high credit ratings before the crisis. With the 2009 update to its corporate CDO rating methodology, Standard &amp; Poor’s was the first rating agency to embrace measures designed to mitigate model risk. Those measures included calibrating the methodology’s simulation model against external benchmarks and adding outside-the-model tests. Today, with the benefit of experience from the crisis, CDO investors should be wary of relying on any analytic methodology that does not specifically address model risk. <b>TOPICS:</b>CLOs, CDOs, and other structured credit, information providers/credit ratings

Do Multiple Credit Ratings Signal Complexity? Evidence from the European Triple-A Structured Finance Securities

In much of the current research on market practices with respect to the use of credit ratings, the rating shopping hypothesis and the information production hypothesis feature prominently. Both of these hypotheses predict an inverse relationship between the number of ratings and a security’s funding cost; that is, more ratings will reduce funding costs and, conversely, fewer ratings will increase funding costs. Our study finds precisely the opposite to have been the case for the mainstay of the structured finance securities market in Europe prior to 2007, namely the triple-A tranches of European residential mortgage-backed securities. Our findings suggest that structured finance markets may behave differently than what would be predicted by two hypotheses traditionally used to explain the number of ratings and funding costs: the rating shopping and information production hypotheses. Obtaining multiple credit ratings may be a signal for complexity, for which investors demand a risk premium.

Liquidity Coverage Ratio Requirement Increases Cost of Securitization for U.S. Banks

In September 2014, the Office of the Comptroller of the Currency (OCC), the Board of Governors of the Federal Reserve System, and the Federal Deposit Insurance Corporation (FDIC) adopted a final rule regulating the liquidity risk of banks in the United States. The Final Rule will impact banks participating in the securitization market in many ways and the authors summarize three of them in this article. First, the Final Rule will increase the cost of unfunded commitments extended by a bank in a securitization credit facility transaction. Second, the Final Rule will increase the costs incurred by a bank that sponsors a securitization of its own assets. Third, the Final Rule will decrease a bank’s appetite to invest in structured finance securities. It remains to be seen whether the new regulation designed to improve the liquidity risk profile of banks will reduce overall market liquidity by steering banks away from the securitization market.

Final Demand for Structured Finance Securities

Structured finance boomed during the run-up to the Financial Crisis. Existing explanations for this growth emphasize supply-side factors. Demand, however, was also encouraged by efforts to avoid regulatory capital requirements. We show that life insurance companies exposed to unrealized losses from low interest rates in the early 2000s increased their holdings of highly rated securitized assets, assets which offered the highest yield per unit of required capital. The results are only evident in accounts subject to capital requirements and at firms with low levels of ex ante capital, consistent with regulation creating distortionary incentives fueling the demand for securitized assets.

The impact of collateralized debt obligation arbitrage on tranching and financial leverage of structured finance securities

For several years leading up to the outbreak of the financial crisis, growth in the use of arbitrage collateralized debt obligations (CDOs) was explosive. In this paper, we discuss potential sources of such arbitrage opportunities, in particular, potential gains due to "bond-like pricing". For this purpose, we examine the risk profiles of CDOs in some detail, which reveals significant differences between CDO tranches and corporate bonds, in particular concerning a considerably increased sensitivity to systematic risks. Treating the structured products as singlename instruments allows us to quantify these differences. We then price CDO tranches approximately with the Merton model, similar to corporate bonds. Using a sample CDO portfolio, we describe some opportunities for "CDO arbitrage" when investors consider corporate and CDO bonds as substitute investments and use bond-like pricing. We then discuss how tranches with high systematic risk can be generated and how CDO arrangers can exploit this to their advantage. It comes as no surprise that precisely these types of structures featured in many of the CDOs issued prior to the outbreak of the financial crisis.

Financial Markets Uncertainty and the Rawlsian Argument for Central Counterparty Clearing of OTC Derivatives

One of the key measures in the Dodd-Frank Act intended to curb systemic risk in the financial system is the central counterparty (CCP) clearing mandate for over-the-counter derivatives. The mandate reflects the belief of legislators and many financial markets experts that these derivatives, particularly credit default swaps, were a key cause of the financial crisis of 2008. While derivative markets do create extensive interconnections between financial institutions, and were essential to the creation of the structured finance securities that fueled the housing bubble, in hindsight it appears that derivatives were not a proximate cause but more likely one of many ‘but for’ structural causes of the crisis. As a result, the CCP clearing mandate has come in for extensive criticism on the grounds that it carries with it significant risks for the global financial system, while providing little benefit in return. This Article offers a critical examination of the arguments against CCP clearing and a defense of the mandate and other Dodd-Frank Title VII derivatives provisions. Beginning with the fundamental uncertainty about the true causes of the crisis that remains, including a strong probable role for a ‘behavioral’ cause of the crisis on account of the panic of financial institutions, it then examines the arguments against CCP clearing, finding that they rely on overly narrow boundaries in order to achieve a measure of precision in making a cost-benefit analysis, thereby ignoring many of the important costs that derivatives indirectly contributed to. Given that a more complete cost-benefit analysis appears to run aground on the complexity of accurately enumerating all the costs and benefits associated with modern financial markets, this Article instead proposes looking at the problem of derivatives regulation through a Rawlsian framework. Central to Rawls’s thought is the procedure of decision-making under conditions of fundamental uncertainty, or the maximin rule. I argue that application of the maximin rule is appropriate here, and that unlike the standard cost-benefit analysis grounded in utilitarianism, Rawls’s views lead to a holistic understanding of the financial markets in their larger societal context that both guides and justifies legislative action in the context of fundamental uncertainty by prioritizing the safety of the financial system. Such a holistic understanding of economic regulation is necessary as governments struggle to preserve social stability in the face of widespread economic challenges such as unemployment, income inequality, excessive debt, and continuing instability in the financial system.

Integration of Structured Finance Exposures in theBasel II Model: Analytical Results

For efficiency reasons or because of a lack of detailed data, financial institutions frequently treat structured finance securities similar to conventional fixed-income products such as bonds or loans, which are characterized by rating, correlation, and loss-given default. Structured finance securities, however, have a specific risk profile. They tend to concentrate losses in adverse states of the systematic risk factor. This fact implies that simply adopting risk parameters of conventional bonds or loans is an inappropriate technique. The author shows that, under the Basel II framework, tranches have to be modeled with an increased factor loading. They derive an analytical calibration procedure for the Basel II model that appropriately captures the risk profile of tranches. This finding not only allows for seamless integration of structured and conventional exposures in a portfolio model, but also offers insights into the concentration effects of tranches.

The Credit Rating Crisis

Since June 2007, the creditworthiness of structured finance products has deteriorated rapidly. The number of downgrades in November 2007 alone exceeded 2,000 and many downgrades were severe, with 500 tranches downgraded more than 10 notches. Massive downgrades continued in 2008. More than 11,000 of the downgrades affected securities that were rated AAA. This paper studies the credit rating crisis of 2007-2008 and in particular describes the collapse of the credit ratings of ABS CDOs. Using data on ABS CDOs we provide suggestive evidence that ratings shopping may have played a role in the current crisis. We find that tranches rated solely by one agency, and by S&P in particular, were more likely to be downgraded by January 2008. Further, tranches rated solely by one agency are more likely to suffer more severe downgrades.(This abstract was borrowed from another version of this item.)

The Risks in CDO-Squared Structures

The recent sub-prime debacle has brought ‘innovative’ structured credit products such as collateralized debt obligations under severe criticism. The complexity of some structured finance securities and difficulties in understanding their risks has been a common theme. This paper argues that CDO-squared structures can be so complex as to make risk assessment difficult. By modeling a simplified CDO-squared structure using Monte Carlo simulation, two of the risks unique to such structures are examined: default location risk and overlap risk. Failure to take account of these risks during a distressed credit environment will result in greater than anticipated losses among senior CDO-squared tranches.

Assessing the Credit Risk of CDOs Backed by Structured Finance Securities

The collateralized debt obligation (CDO) market grew strongly in the last several years thanks to a strong U.S. housing market, a low interest rate environment, abundant global excess liquidity, and a healthy U.S. economy. The growth slowed significantly in 2007 amidst an unprecedented housing market turnaround and the sudden performance deterioration of recent-vintage subprime residential mortgage-backed securities (RMBS). CDOs9 large exposure to these subprime RMBS brought them under intense scrutiny. The illiquidity, novelty, and complexity of CDOs made them easy targets of criticism. This paper describes the evolution of CDOs backed by structured finance securities (SF CDOs) and the analytical approaches used by Moody9s to rate SF CDOs. We show that SF CDOs have experienced substantial changes in the last eight years in terms of asset distribution and transaction structure. We find that this sector has been dominated by Aaa-rated securities (about 85% by dollar volume of issuance), which had not experienced any defaults and losses as of the end of 2006. Although recently issued SF CDOs are expected to perform poorly, not all SF CDOs are backed by subprime RMBS and CDO performance is expected to vary significantly across transactions. This paper also describes Moody9s methods for the modeling of four basic components—default probability, recovery rate, asset correlation, and prepayment rate—and the differences and similarities across different rating models for transactions with and without complex waterfalls. Additionally, we analyze the rationale of a number of structural features such as par haircuts on assets with low credit ratings and assets purchased at deep discounts in SF CDOs as well as additional stresses that are designed to protect SF CDO investors. Finally, we note that the changing distribution of CDO assets and the different credit cycles to which these assets have been subjected make it difficult to interpret the average statistics computed for the overall CDO sector during a short data sample period that covers only a part of the credit cycle for each asset type. <b>TOPICS:</b>CLOs, CDOs, and other structured credit, project finance, legal and regulatory issues for structured finance

Assessing the Credit Risk of CDOs Backed by Structured Finance Securities: Rating Analysts' Challenges and Solutions

The CDO market grew strongly in the last several years thanks to a strong U.S. housing market, a low interest rate environment, abundant global excess liquidity, and a healthy U.S. economy. The growth slowed significantly in 2007 amidst an unprecedented housing market turnaround and the sudden performance deterioration of recent-vintage subprime residential mortgages-backed securities (RMBS). CDOs' large exposure to these subprime RMBS brought them under intense scrutiny. The illiquidity, novelty, and complexity of CDOs made them easy targets of criticism. This paper describes the evolution of CDOs backed by structured finance securities (SF CDOs) and the analytical approaches used by Moody's to rate SF CDOs. We show that SF CDOs have experienced substantial changes in the last eight years in terms of asset distribution and transaction structure. We find that this sector has been dominated by AAA-rated securities (about 85% by dollar volume of issuance), which did not experience any defaults and losses as of the end of 2006. Although recently issued SF CDOs are expected to perform poorly, not all SF CDOs are backed by subprime RMBS and CDO performance is expected to vary significantly across transactions. This paper also describes Moody's methods for the modeling of four basic components - default probability, recovery rate, asset correlation, and prepayment rate - and the differences and similarities across different rating models for transactions with and without complex waterfalls. Additionally, we analyze the rationale of a number of structural features such as par haircuts on lowly rated assets and assets purchased at deep discount in SF CDOs and additional stresses that are designed to protect SF CDO investors. Finally, we note that the changing distribution of CDO assets and the different credit cycles to which these assets have been subjected make it difficult to interpret the average statistics computed for the overall CDO sector during a short data sample period that covers only a part of the credit cycle for each asset type.

The Relationship Between Issuance Spreads and Credit Performance of Structured Finance Securities

This article analyzes the relationship between structured finance par coupon spreads at issuance and the securities9 credit performance. Using floating and fixed rate structured finance securities that include asset-backed, mortgage-backed, and collateralized debt obligations issued in the U.S. during 1998-2004, we find spreads vary substantially by rating, over time, and across asset classes; the spreads on structured finance securities are correlated with, and generally wider than, those on similarly rated corporate securities. Highly rated securities such as those rated Aaa contain more systematic risk components than do lowly rated ones such as those rated Baa. Spreads are backward looking in the sense that new issue spreads widen after downgrade rates rise on outstanding securities within the same asset class. Spreads also anticipate future credit performance in the sense that securities with wider spreads at issuance (conditional on sector, rating, and general market conditions) are more likely to experience subsequent rating downgrades than other securities.

Default Rates on Structured Finance Securities

Default Rates on Structured Finance Securities

Investigating Recovery and Loss Behavior of Defaulted U.S. Structured Finance Securities

Loss severity (or recovery) given default is critical in calculating expected loss and the understanding of credit risk. This report provides the market with additional insight and transparency into the principal repayment and realized loss characteristics of defaulted U.S. structured finance securities. The report provides a cross-sectional regression analysis and examines the largest number of observations to date, thus providing added statistical weight to its findings. The report also gives the market additional analysis for some of the more uncertain aspects of recovery and loss severity rates in structured securities.

Explaining Launch Spreads on Structured Bonds

We investigate determinants of launch spreads in European securitization transactions over the last decade. First, we develop a simple, reduced-form pricing model for all issues across different transaction types and test it. We document the critical importance of credit ratings without refinements as the key pricing factors for structured finance securities at launch. Next, we show that other price determinants, such as placement characteristics, are consistently significant in their impact on spreads and delineate the opposing effects of liquidity and market segmentation. Finally, we show that other factors that might directly affect investors’ payoffs, such as creditors’ rights, exhibit consistent relationships to launch spreads beyond the credit rating. Hence, we conjecture that credit rating agencies systematically differ from investors in their assessment of certain issues’ and markets’ characteristics.