Tranching and Rating Brennan, Hein, and Poon Comments by Mark Flannery Financial Innovations and...
-
Upload
beverly-harrington -
Category
Documents
-
view
220 -
download
0
Transcript of Tranching and Rating Brennan, Hein, and Poon Comments by Mark Flannery Financial Innovations and...
![Page 1: Tranching and Rating Brennan, Hein, and Poon Comments by Mark Flannery Financial Innovations and Crises, May 11-13, 2009.](https://reader036.fdocuments.in/reader036/viewer/2022082611/56649ed45503460f94be4d46/html5/thumbnails/1.jpg)
Tranching and RatingBrennan, Hein, and Poon
Comments byMark Flannery
Financial Innovations and Crises, May 11-13, 2009
![Page 2: Tranching and Rating Brennan, Hein, and Poon Comments by Mark Flannery Financial Innovations and Crises, May 11-13, 2009.](https://reader036.fdocuments.in/reader036/viewer/2022082611/56649ed45503460f94be4d46/html5/thumbnails/2.jpg)
Motivation
Many CDOsLarge 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
![Page 3: Tranching and Rating Brennan, Hein, and Poon Comments by Mark Flannery Financial Innovations and Crises, May 11-13, 2009.](https://reader036.fdocuments.in/reader036/viewer/2022082611/56649ed45503460f94be4d46/html5/thumbnails/3.jpg)
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
![Page 4: Tranching and Rating Brennan, Hein, and Poon Comments by Mark Flannery Financial Innovations and Crises, May 11-13, 2009.](https://reader036.fdocuments.in/reader036/viewer/2022082611/56649ed45503460f94be4d46/html5/thumbnails/4.jpg)
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
![Page 5: Tranching and Rating Brennan, Hein, and Poon Comments by Mark Flannery Financial Innovations and Crises, May 11-13, 2009.](https://reader036.fdocuments.in/reader036/viewer/2022082611/56649ed45503460f94be4d46/html5/thumbnails/5.jpg)
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
![Page 6: Tranching and Rating Brennan, Hein, and Poon Comments by Mark Flannery Financial Innovations and Crises, May 11-13, 2009.](https://reader036.fdocuments.in/reader036/viewer/2022082611/56649ed45503460f94be4d46/html5/thumbnails/6.jpg)
Firm’s Asset Value DistributionProbabilities
Vmax
Physical probabilities
V~
6
![Page 7: Tranching and Rating Brennan, Hein, and Poon Comments by Mark Flannery Financial Innovations and Crises, May 11-13, 2009.](https://reader036.fdocuments.in/reader036/viewer/2022082611/56649ed45503460f94be4d46/html5/thumbnails/7.jpg)
Positive Beta and State PricesProbabilities
Vmax
Physical probabilities
Risk neutral probabilities
V~
7
![Page 8: Tranching and Rating Brennan, Hein, and Poon Comments by Mark Flannery Financial Innovations and Crises, May 11-13, 2009.](https://reader036.fdocuments.in/reader036/viewer/2022082611/56649ed45503460f94be4d46/html5/thumbnails/8.jpg)
Mispricing Cash-flows’ Beta
V~
maxV
Bond Payoffs ($)
F8
![Page 9: Tranching and Rating Brennan, Hein, and Poon Comments by Mark Flannery Financial Innovations and Crises, May 11-13, 2009.](https://reader036.fdocuments.in/reader036/viewer/2022082611/56649ed45503460f94be4d46/html5/thumbnails/9.jpg)
Mispricing Cash-flows’ Beta
V~
maxV
Bond Payoffs ($)
F
Credit Risk Premium, physical probabilities
“Rf”
9
![Page 10: Tranching and Rating Brennan, Hein, and Poon Comments by Mark Flannery Financial Innovations and Crises, May 11-13, 2009.](https://reader036.fdocuments.in/reader036/viewer/2022082611/56649ed45503460f94be4d46/html5/thumbnails/10.jpg)
Β > 0 Promise higher repayment
V~
maxVF F’10
![Page 11: Tranching and Rating Brennan, Hein, and Poon Comments by Mark Flannery Financial Innovations and Crises, May 11-13, 2009.](https://reader036.fdocuments.in/reader036/viewer/2022082611/56649ed45503460f94be4d46/html5/thumbnails/11.jpg)
Asset Variance and Default LossesProbabilities
V~
PD=5% PD=5%
“A” rated Bond repayment, LOW variance. “A” rated Bond
repayment, HIGH variance.
11
![Page 12: Tranching and Rating Brennan, Hein, and Poon Comments by Mark Flannery Financial Innovations and Crises, May 11-13, 2009.](https://reader036.fdocuments.in/reader036/viewer/2022082611/56649ed45503460f94be4d46/html5/thumbnails/12.jpg)
V~
maxV
Bond Payoffs ($)
F
Rf
Reference Bond
Risk Premium on a Reference Bond’s Volatility
12
![Page 13: Tranching and Rating Brennan, Hein, and Poon Comments by Mark Flannery Financial Innovations and Crises, May 11-13, 2009.](https://reader036.fdocuments.in/reader036/viewer/2022082611/56649ed45503460f94be4d46/html5/thumbnails/13.jpg)
V~
maxVF F’
Mispricing Asset Return Variance
13
![Page 14: Tranching and Rating Brennan, Hein, and Poon Comments by Mark Flannery Financial Innovations and Crises, May 11-13, 2009.](https://reader036.fdocuments.in/reader036/viewer/2022082611/56649ed45503460f94be4d46/html5/thumbnails/14.jpg)
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
![Page 15: Tranching and Rating Brennan, Hein, and Poon Comments by Mark Flannery Financial Innovations and Crises, May 11-13, 2009.](https://reader036.fdocuments.in/reader036/viewer/2022082611/56649ed45503460f94be4d46/html5/thumbnails/15.jpg)
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
![Page 16: Tranching and Rating Brennan, Hein, and Poon Comments by Mark Flannery Financial Innovations and Crises, May 11-13, 2009.](https://reader036.fdocuments.in/reader036/viewer/2022082611/56649ed45503460f94be4d46/html5/thumbnails/16.jpg)
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 cross-
security distinctions?
16
![Page 17: Tranching and Rating Brennan, Hein, and Poon Comments by Mark Flannery Financial Innovations and Crises, May 11-13, 2009.](https://reader036.fdocuments.in/reader036/viewer/2022082611/56649ed45503460f94be4d46/html5/thumbnails/17.jpg)
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?
17