Hi everyone,
thought of asking, why did CDOs (Collateralized Debt Obligations) got a high AAA rating from the credit rating agencies? were there any mistakes done by credit rating agencies that led to the subprime mortgage crsis? thanks!
It was less of an issue with individual issues pre CDOs as CRAs didn’t have to assume cross default correlations in their model. With the introduction of CDOs came huge fees for the banks that underwrote them and for the CRAs that rated them who have to compete with each other for new business. For example Fitch admitted that the whole model only works if housing price kept going up and they severely underestimated the cross default correlation of the mortgages within the CDO pool, which is even worse for CDO squares derived from it.
Regulators also didn’t help by requiring less regulatoratory capital for banks holding triple a rated CDOs that yielded higher interest than regular securities.
Yield hungry Investors also were also at fault to some extend by accepting the amount of risk in those CDOs without requiring adequate return to justify their high exposure to market risk.
Ah brings back mememories…
PA: [early '07] we probably shouldn’t be holding these CDOs
CFO: why, what does the Fitch rating say?
PA: A-, if you believe that’s real
CFO [march '08]: PA get in my office, what is going on with our CDOs today!!??
PA: there is no market price, they are froze
CFO: but what is the Fitch rating?
PA: A-
CFO: but that doesn’t make any sense!
PA: by the way I got a job outside of fixed income, giving two weeks notice, have fun with your froze assets
you passed level 3?
all about historic prime loss assumptions being used on subprime loans and assumptions home prices will keep going up
^ and thus also about a lack of basic analytical skills.
The whole CDO does not get rated “AAA”; only a specific tranche of it does. The whole CDO may have $500MM of assets collateralizing its liabilities. The highest rated tranche will be AAA and will be $325MM, with the lower level/subordinate tranches capitalizing the rest of the CDO. Banks and insurance companies may buy the AAA rated tranche (returns are typically low, such as L+150 bps), with hedge funds, specialized credit funds and other institutions with higher risk tolerances buying the subordinated tranches
The subordinate tranches will take first losses; the AAA rating on that tranche is reflective of all the subordinated capital/loss protection behind it, and not the assets the CDO owns.
The role of CDOs in the financial crisis is so badly misunderstood it’s tragic.
The main reason I’ve heard (since I never worked with them myself) is that the models had assumed historical correlations of default rates even though the actual pool of borrowers was increasingly low quality. If the new borrowers defaulted at the same rate (or less) as the old borrowers, it was fine, but if they defaulted at higher rates and were extra sensitive to some macroeconomic factor, then the correlation of defaults would be much higher, and the tranches that paid best would go to zero very fast.
An interesting alternative that someone told me is that he AAA ratings were only about the ability of a vehicle to pay what it was contractually required to pay (similar to ratings on floating rate bonds). The way the CDO tranche contracts were written, if more than a certain percentage of underlying debt instruments defaulted, there was no obligation to pay anything. Because the obligation was reduced, the chance of not paying what was agreed to was also reduced. So you might think AAA meant a sure chance of getting your money, but it only meant a sure chance of getting paid what was agreed in the CDO contract, which included the possibility of being paid nothing.