The Economics of Structured Finance
Introduction (Joshua D. Coval Jakub Jurek Erik Stafford @ Harvard)
The essence of structured finance activities is the pooling of economic assets (e.g. loans, bonds, mortgages) and subsequent issuance of a prioritized capital structure of claims, known as tranches, against these collateral pools. As a result of the prioritization scheme used in structuring claims, many of the manufactured tranches are far safer than the average asset in the underlying pool. This ability of structured finance to repackage risks and create “safe” assets from otherwise risky collateral led to a dramatic expansion in the issuance of structured securities, most of which were viewed by investors to be virtually risk-free and certified as such by the rating agencies. At the core of the recent financial market crisis has been the discovery that these securities are actually far riskier than originally advertised.
We examine how the process of securitization allowed trillions of dollars of risky assets to be transformed into securities that were widely considered to be safe, and argue that two key features of the structured finance machinery fueled its spectacular growth. First, we show that most securities could only have received high credit ratings if the rating agencies were extraordinarily confident about their ability to estimate the underlying securities’ default risks, and how likely defaults were to be correlated. Using the prototypical structured finance security – the collateralized debt obligation (CDO) – as an example, we illustrate that issuing a capital structure amplifies errors in evaluating the risk of the underlying securities. In particular, we show how modest imprecision in the parameter estimates can lead to variation in the default risk of the structured finance securities which is sufficient, for example, to cause a security rated AAA to default with reasonable likelihood. A second, equally neglected feature of the securitization process is that it substitutes risks that are largely diversifiable for risks that are highly systematic. As a result, securities produced by structured finance activities have far less chance of surviving a severe economic downturn than traditional corporate securities of equalrating. Moreover, because the default risk of senior tranches is concentrated in systematically adverse economic states, investors should demand far larger risk premia for holding structured claims than for holding comparably rated corporate bonds. We argue that both of these features of structured finance products – the extreme fragility of their ratings to modest imprecision in evaluating underlying risks and their exposure to systematic risks – go a long way in explaining the spectacular rise and fall of structured finance.