Tranching and Rating
Brennan, Hein, and Poon
Comments by
Mark Flannery
Financial Innovations and Crises, May 11-13, 2009
Motivation
Many CDOs
Large 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.
2
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.
3
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)
4
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.
5
Firm’s Asset Value Distribution
Probabilities
Physical probabilities
Vmax
~
V
6
Positive Beta and State Prices
Probabilities
Physical probabilities
Risk neutral probabilities
Vmax
~
V
7
Mispricing Cash-flows’ Beta
Bond Payoffs ($)
~
V
F
Vmax
8
Mispricing Cash-flows’ Beta
Bond Payoffs ($)
Credit Risk Premium,
physical probabilities
“Rf ”
~
V
F
Vmax
9
Β > 0  Promise higher repayment
F
F’
~
V
Vmax
10
Asset Variance and Default Losses
Probabilities
PD=5%
“A” rated Bond
repayment, LOW
“A” rated Bond
variance.
repayment, HIGH
variance.
PD=5%
~
V
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Risk Premium on a Reference Bond’s Volatility
Reference
Bond
Bond Payoffs ($)
Rf
~
V
F
Vmax
12
Mispricing Asset Return Variance
Vmax
F
F’
~
V
13
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?
14
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
15
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 crosssecurity 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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