Content area
Full Text
Thank goodness for risk. Investors get paid to take risk, and analysts get paid to write about it. Curve risk, spread risk, liquidity risk, credit risk, prepayment risk, structural risk, and other risks are on proiessionals' radar screens all the time. Measuring and pricing risk correctly are central functions for many, if not most, finance professionals.
Yet some risks lend themselves to analysis more readily than others. One that presents formidable challenges all the time is model risk, the risk that a model does not describe reality well enough to produce reliable results.
In the past two years, certain areas of the securitization market have suffered disappointing levels of defaults and credit deterioration. The collateralized debt obligation, aircraft assetbacked securities, franchise loan ABS, and 12b-1 fee ABS sectors have been hammered by unprecedented volumes of downgrades.
A common theme in these sectors-and a probable explanation for the disappointing performance-is model risk. The most popular models and analytic techniques for measuring credit risk in the assets backing such deals seemingly failed to capture linkages and the changing degrees of linkage among the credit risks of the securitized assets. The economics literature addresses such linkages and changing linkages under the rubrics of correlation and time-varying correlation.
Most securitization professionals agree that the credit risks on separate assets can be linked. Most would readily acknowledge the possibility that the degree of a linkage can change with the passage of time. Monte Carlo simulations and other analytic techniques used to analyze the credit risks of CDOs, aircraft ABS, franchise loan ABS, and 12b-1 fee ABS sometimes do not address linkages in a rigorous manner, however, and generally do not reflect changing degrees of linkage at all. This shortcoming may have caused these techniques to undcrprcdict the level of losses under recent stressful conditions-model risk coming home to roost.1
CDOs: In the CDO sector, both S&P and Moody s took record numbers of downgrade actions in 2002 (Elengical et al. [2003]; Fu and Harris [2003]; Nazarian et al. [2003]; and Tung [2003]). Moody's took downgrade actions on CDOs 747 times during the year. Moody s rating actions hit 471 of the 4,921 outstanding CDO tranches. S&P took 306 downgrade actions.
Both rating agencies identify the poor performance of the...