Structured Credit Market Unlikely Ever to Fully Recover
The market for collateralized debt obligations is unlikely ever to fully recover from the credit crunch, no matter how much better the credit rating agencies get at assessing the risks of the complex structured finance derivatives, a new working paper* published by Harvard Business School argues.
Some practitioners believe that the credit crunch of 2007 and 2008 will work itself out, as such episodes tend to do, and the market for structured credit will return as before, the paper’s authors write.
We hold the more skeptical view that the market for structured credit appears to have serious structural problems that may be difficult to overcome.
“As we have explained, these claims are highly sensitive to the assumptions of (1) default probability and recovery value, (2) correlation of defaults, and (3) the relation between payoffs and the economic states that investors care about most. Beginning in late 2007 and continuing well into 2008, it became increasingly clear to investors in highly-rated structured products that each of these three key assumptions were systematically biased against them. These investors are now reluctant to invest in securities that they do not fully understand.”
The ability to create large quantities of AAA-rated securities from a given pool of underlying assets is likely to be forever diminished, as the rating process evolves to better account for parameter and model uncertainty, the authors write. “The key is recognizing that small errors that would not be costly in the single-name market, are significantly magnified by the collateralized debt obligation structure, and can be further magnified when CDOs are created from the tranches of other collateralized debt obligations, as was common in mortgage-backed securitizations. The good news is that this mistake can be fixed. For example, a Bayesian approach that explicitly acknowledges that parameters are uncertain would go a long way towards solving this problem. Of course, adopting a Bayesian perspective on parameter uncertainty will necessarily mean far less AAA-rated securities can be issued and therefore fewer opportunities to offer investors attractive yields.”
“Additionally, investors need to recognize the fundamental difference between single name and structured securities, when it comes to exposure to systematic risk. Unlike traditional corporate bonds, whose fortunes are primarily driven by firm-specific considerations, the performance of securities created by tranching large asset pools is strongly affected by the performance of the economy as a whole. In particular, senior structured finance claims have the features of economic catastrophe bonds, in that they are designed to default only in the event of extreme economic duress.”
Because credit ratings are silent regarding the state of the world in which default is likely to happen, they do not capture this exposure to systematic risks. The lack of consideration for these types of exposures reduces the usefulness of ratings, no matter how precise they are made to be.
*The Economics of Structured Finance by Joshua D. Coval (Harvard), Jakub Jurek (Princeton), Erik Stafford (Harvard).
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