[Risk Analysis in Correlation Products: Using CDO's as Evidence]

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Abstract

We use the information in collateralized debt obligations (CDO) prices to study market expectations about how corporate defaults cluster. A three-factor portfolio credit model explains virtually all of the time-series and cross-sectional variation in an extensive data set of CDX index tranche prices. Tranches are priced as if losses of 0.4%, 6%, and 35% of the portfolio occur with expected frequencies of 1.2, 41.5, and 763 years, respectively. On average, 65% of the CDX spread is due to firm-specific default risk, 27% to clustered industry or sector default risk, and 8% to catastrophic or systemic default risk.

A collateralized debt obligation (CDO) is a financial claim to the cash flows generated by a portfolio of debt securities or, equivalently, a basket of credit default swaps (CDS contracts). Thus, CDOs are the credit market counterparts to the familiar collateralized mortgage obligations (CMOs) actively traded in secondary mortgage markets. Since its inception in the mid-1990s, the market for CDOs has become one of the most rapidly growing financial markets ever. Industry sources estimate the size of the CDO market at the end of 2006 to be nearly $2 trillion, representing more than a 30% increase over the prior year. Recently, CDOs have been in the spotlight because of the May 2005 credit crisis in which downgrades of Ford's and General Motors' debt triggered a wave of large CDO losses among many credit-oriented hedge funds and Wall Street dealers. Despite the importance of this market, however, relatively little research on CDOs has appeared in the academic literature to date.

CDOs are important not only to Wall Street, but also to researchers since they provide a near-ideal “laboratory” for studying a number of fundamental issues in financial economics. For example, CDOs allow us to identify the joint distribution of default risk across firms since CDOs are claims against a portfolio of debt, information that cannot be inferred from the marginal distributions associated with single-name credit instruments. The joint distribution is crucial to understanding how much credit risk is diversifiable and how much contributes to the systemic risk of “credit crunches” and liquidity crises in financial markets. Furthermore, clustered default risk has implications for the corresponding stocks since default events may map into nondiversifiable event risk in equity markets.

CDO-like structures are emerging as a major new type of financial vehicle and/or “virtual” institution. In particular, the CDO structure can be viewed as an efficient special purpose vehicle for making illiquid assets tradable, creating new risk-sharing and insurance opportunities in financial markets, and compLeting ...