A little knowledge is a dangerous thing: model specification, data history, and CDO (mis)pricing

Abstract

The revaluation of collateralized debt obligations (CDOs) plays a significant role in the ongoing 2007-2009 credit crisis. Starting in August 2007, a large amount of initially AAA rated CDO securities are substantially downgraded, some directly to junk grade. This paper explores two structural sources of CDO mispricing: modeling difficulty and data limitation. Simulating the frailty correlated default model of Duffie, Eckner, Horel, and Saita (2009), we show that CDO mis-pricing can be partly attributed to model misspecifications, as well as limited availability of historical data on CDO collateral assets. This simulation result is consistent with empirical evidence of a sample of 279 CDOs. The frailty model estimated with adequate historical data would have reduced the amount of AAA rated CDO securities by 12% on average. The frailty model has predictive power for the subsequent downgrading of AAA rated CDO tranches. Our study addresses practical issues on financial innovations and provides guidance for corresponding risk management.