Tranching and RatingBrennan, Hein, and Poon

Comments byMark Flannery

Financial Innovations and Crises, May 11-13, 2009

Motivation

Many CDOsLarge majority were “arbitrage” issuances,

inconsistent with arbitrage-free asset pricing.Why?

Moreover, bond CDOs had many tranches.Why?

E.g., could manufacture AAA tranches with only one subordinated tranche.

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Hypothesis: Some Investors Mis-value Complex Securities

• Sophisticated investors properly price corporate bonds.

• Naïve investors price complex securities according to ratings.

Selling securities to naïve investors should permit profits.

Paper shows how those profits depend on multiple tranches.

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Hypothesized Security Pricing

• Ratings-based investors consider– Possible cash flows– Physical probabilities (pi)

• “True” security value depends on – (Possible cash flows)*(state prices)– “risk-neutral probabilities” (qi)

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Sources of CDO Mis-valuation

1) Bonds default in high-value states (if β > 0)

2) Bond’s cash flows have high variance relative to “reference” bond the rating agency has in mind.

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Firm’s Asset Value DistributionProbabilities

Vmax

Physical probabilities

V~

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Positive Beta and State PricesProbabilities

Vmax

Physical probabilities

Risk neutral probabilities

V~

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Mispricing Cash-flows’ Beta

V~

maxV

Bond Payoffs ($)

F8

Mispricing Cash-flows’ Beta

V~

maxV

Bond Payoffs ($)

F

Credit Risk Premium, physical probabilities

“Rf”

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Β > 0 Promise higher repayment

V~

maxVF F’10

Asset Variance and Default LossesProbabilities

V~

PD=5% PD=5%

“A” rated Bond repayment, LOW variance. “A” rated Bond

repayment, HIGH variance.

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V~

maxV

Bond Payoffs ($)

F

Rf

Reference Bond

Risk Premium on a Reference Bond’s Volatility

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V~

maxVF F’

Mispricing Asset Return Variance

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Issues: #1

Model provides a hypothesis that is consistent with multiple tranches.

Is it consistent with the data? Were the bonds selected for CDOs

1. Higher beta?2. Higher asset volatility?3. Correlated with one another?

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Issue #2

Can other hypotheses generate same prediction re: multiple junior tranches?

E.g. knowing investors purchased these tranches as a way to write out-of-the money puts. – Hence “earn alpha”– Hence earn asymmetric hedge fund fees

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Issue #3

What to do about rating agencies?• Credibility may be slightly damaged (!)• Some evidence of poor “care” on CDO ratings,

at least for subprime mortgage pools.• Fairly extensive government/regulatory

reliance on these private firms.• Help set new standards, that reflect cross-

security distinctions?

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Issue #4

Returning to the model here: can it be applied to corporate debt structures?

Higher beta or volatility assets support more complex debt structures?

Or, with unbiased information asymmetries, does higher volatility generate a greater range of selected debt structures?

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