Professor John M. Griffin, McCombs School of Business, University of Texas at Austin
Although commonly considered a driver of the financial crisis, there has been little examination of what can be learned regarding CDO and MBS correlations from the aftermath of the financial crisis. First, we document that the default correlations assumed by credit rating agency when modeling CDOs was around 0.01 for CLOs and 0.03 for ABS CLOs. We show that these assumptions have a large impact on AAA CDO credit support, especially at lower correlation levels. Second, to gauge the appropriate correlation level we adopt a modified approach of Duffie et al (2009) that accounts for unobserved systematic risk. We show that there is considerable systematic frailty that is unaccounted for in corporate bond credit ratings and that this has a large effect on CLO loss distributions. We find that default correlation estimates that incorporate frailty are at least six times those used in CLOs issued prior to the financial crisis. Third, we also examine non-agency housing collateral and find that delinquencies were highly correlated across all geographic regions even prior to the financial crisis. Surprisingly, pre- and post-crisis regional delinquencies in non-agency MBS are similar. Finally, we assess the default correlations assumed for recent CLO issuances. Although rating agencies have increased their post-crisis CLO correlation assumptions, they are not as high as our ‘frailty’ estimates suggest they should be. Our findings suggest caution for buyers relying on ratings of recent structured finance issuances.
Professor John Griffin is currently a Full Professor of Finance and holds a Professorship at the University of Texas. He has also served on the faculty at Arizona State University, Yale University, Hong Kong University of Science and Technology, and Harvard Business School. He serves as the associate editor for the Review of Financial Studies and has been elected as an Academic Director of the Financial Management Association. He is an expert in the structured finance field with respect to mortgage backed securities and collateralised debt obligations. Professor Griffin’s expertise also includes international finance, institutional investment, and forensic finance. Topics of these papers include: the determinants of international returns and diversification, exchange rate exposure, pricing models, anomalies, co-movement, hedge fund performance, IPOs, investment banking, insider trading, credit ratings, the role of reputation, and mortgage misreporting. Professor Griffin’s recent research focuses on understanding the role that conflicts of interest and misreporting by credit rating agencies and investment banks played in the financial crisis.