Why CDOs are just INCORRECTLY priced 'Economic Catastophe' bonds

Why CDOs are economic catastophe bonds, but INCORRECTLY priced. [¹]
Or, What Happens When 'Market Amateurs' Attempt To Price Risk

By Sam Jones, http://ftalphaville.ft.com/blog/ | 5 October 2007

It’s pretty clear that this summer most of the debt markets have been in some kind of funk. Ironic then, that if you’d bothered to keep up with the latest from Havard Business School back in July, you might have been one of the few wily investors to see the wood from the trees.

Back pre-crunch, three professors at HBS published a detailed paper on CDO tranching. It’s simply titled “Economic Catastrophe Bonds”.

The thrust of Profs. Joshua Covel, Jakub Jurek and Erik Stafford’s argument is that CDOs are grossly mis-priced. The "central insight" of asset pricing they say, is that "a securities value depends on both its distribution of payoffs across economic states and state prices". But,

In fixed income markets, many investors focus exclusively on estimates of expected payoffs, such as credit ratings, without considering the state of the economy in which default is likely to occur… We show that many structured finance instruments can be characterized as economic catastrophe bonds, but offer far less compensation that alternatives with comparative payoff profiles.

In other words, asset pricing— as perpetrated by the rating agencies at the moment— is not a holistic approach, and considers only expected payoffs. As such, there’s a huge dislocation between the values the market has been assigning to senior CDO tranches, and their actual, mathematically modelled value. The distortion has come because of over-reliance on simplistic rating-agency modelling.

In fact, the only accurately priced CDO paper, say the professors, is what is commonly regarded as 'toxic'— the equity tranch. At the bottom, the chance of a loss is supposedly higher, but is still generally a factor of the state of the overall economy: one or two company’s defaulting is pretty random, but is largely absorbed by the highly diversified nature of the CDO portfolio. The risk of loss at the top tranches, however is purely a function of the economy, and is thus far less diversified for the spread being paid:

The prioritization rule allows senior tranches to have low default probabilities and garner high credit ratings. However, it also confines senior tranche losses to systemically bad economic states, effectively creating economic catastrophe bonds… Securities that fail to deliver their promised payments in the "worst" economic states will have low values, because these are precisely the states where a dollar is most valuable.

And by factoring systemic, economic risks into the standard Merton credit model, the study finds that for the same economic risks taken by senior CDO tranche investors, three times as much compensation could simply be earned by writing out-of-the-money put spreads on the market:


Click Here, or on the image, to see a larger, undistorted image.

During the boom in the credit markets, banks packaged CDOs such that AAA-rated tranches would pay a few basis points more than AAA-rated bonds. But,

A naive application of the law of one price says that a triple-A security should have the same yield as any other triple-A security… CDO arrangers added value by giving you this yield advantage relative to the wrong benchmark… With the right benchmark, you are leaving a lot on the table for the risk you are bearing.

That then, explains why even the most senior debt has been suffering price dislocations over the Summer: investors are being rudely disabused of the notion that all AAAs are equal. Some are more equal— and equitable— than others.

Normxxx    
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