Class, pay attention. Itâs often said that academics live in a bubble. Of course itâs pretty clear that this summer most of the debt markets have been in one. Ironic then, that if youâd 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. Itâs simply titled âEconomic Catastrophe Bondsâ. Need we go on? Well since the hedge funds are sniggering at the back, yes. The thrust of Profs. Joshua Covel, Jakub Jurek and Erik Staffordâs argument is that CDOs are grossly mis-priced. The âcentral insightâ of asset pricing they say, is that âa securities value depends on both its distribution of payoffs across economic states and state pricesâ. 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, thereâs 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 he 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 companyâs 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 âworstâ 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: 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. ______________________________________ Rudely disabused ? Come on ! Grown up people know to interpret "Tripple A" !!! Ha, ha, ha....
Thanks. This is interesting stuff. Is the paper available online? It's long been a mystery to me why so-called sophisticated investors rely on the hopelessly conflicted rating agencies.