DP11145 | Securitisation Bubbles: Structured finance with disagreement about default correlations

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03/01/2016

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Abstract

The early 2000s have seen an enormous boom and bust in structured financial products, such as residential mortgage-backed securities (RMBSs) or collateralised debt obligations (CDOs). The standard 'Gaussian Copula' model used to quantify their credit risk was highly dependent on the choice of a single default correlation parameter that often required subjective judgement, as underlying assets were not standardised or only had a short history. This paper shows how moderate disagreement about default correlation increases the market value of the structured collateral considerably above that of its total cash-flow, as investors self-select into buying tranches they value more highly than others. The implied 'return to tranching' is sizeable for a typical RMBS, and an order of magnitude larger for CDOs backed by RMBS-tranches, whose cash-flow distribution is not bounded by a minimum recovery value and thus more sensitive to heterogeneous default correlations. In contrast, disagreement about average default probabilities, or recovery values, does not imply a large return to tranching.