Tuesday, February 21, 2012

The Economics of Structured Finance

For anyone interested in the financial crisis, I thought I'd try to summarize a paper I just read for my Empirical Macroeconomics and Finance course. The paper is called "The Economics of Structured Finance," by Coval, Jurek, and Stafford, 2009, in the Journal of Economic Perspectives, Volume 23, Number 1.

Structured finance is the pooling of economic assets and subsequent issuance of a prioritized capital structure of claims, called tranches, against these collateral pools. The prototypical example of a structured finance security is a collateralized debt obligation (CDO).

A reason that the practice of structuring securities arose was to allow the tranches to be rated by the credit rating agencies so that they could be comparable with single-name securities or corporate bonds. Securities involve a complex mix of risks. Adding the prioritization structure creates “safe” assets at the high priority senior tranches. Senior tranches only absorb losses after the junior claims have been exhausted, which allows senior tranches to obtain credit ratings in excess of the average rating for the whole collateral pool.

For example, consider two bonds, both with default probability p. Both pay $0 in case of default and $1 otherwise. You could pool them into a $2 fund, and then form a junior and senior tranche. The junior tranche pays $1 if both bonds avoid default and $0 if either bond defaults. The senior pays $1 if neither bond defaults or if only one out of two bonds defaults; it pays $0 if both bonds default.

The recent financial crisis involved the discovery that the “safe” manufactured tranches were actually far riskier than advertised. Even AAA rated securities defaulted with reasonable likelihood. When this was finally realized, in late 2007 and 2008, investors stopped buying structured finance products. How did the credit rating agencies get it so wrong?

Notice that in the example above, the risk of default for the senior tranche depends on the correlation between bond defaults. If the bond default probabilities are uncorrelated, then the senior tranche defaults with probability p2

Next, the authors look at the relation of structured finance to subprime. Government- sponsored agencies such as Fannie Mae, Freddie Mac, and Ginnie Mae were chartered to purchase mortgages originated by local banks that satisfy certain size and credit quality requirements. They repackage these conforming mortgages into mortgage-backed securities to be resold in capital markets with the implicit guarantee of the U.S. government. Mortgages that fall below the credit standard (“subprime”) were packaged into “private-label” mortgage-backed securities, which in turn were resecuritized into structured finance CDOs. So there were two levels of structuring, and a lot more correlations to worry about, which were not properly accounted for. The ratings also didn't take into account systemic risk, which structured finance was particularly susceptible to. Typically, securities that are correlated with the market as a whole should offer higher expected returns, since it is less valuable to have an asset that will pay well when times are good and pay poorly when times are bad, than vice versa. The systemic risk of the structured finance products was underestimated.

The authors don't place all the blame on the credit rating agencies. They partly blame some perverse incentives, and also a regulatory guideline saying that banks holding AAA-rated securities were required to hold only half as much capital as was required to support other investment-grade securities.This distorted the demand for AAA-rated securities, and fueled a lot of the effort to create an imprudently large volume of structured financial products.