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CDOs And The Financial Crisis: Credit Ratings And Fair Premia

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Executive Summary

This paper uses the market-standard Gaussian copula model to show that fair spreads on CDO tranches are much higher than fair spreads on similarly-rated corporate bonds. It implies that credit ratings are not sufficient for pricing, which is surprising given their central role in structured finance markets. Tranche yield enhancement is attributed to a concentration of collateral bonds' risk premia in spreads of non-equity tranches. This illustrates limitations of the rating methodologies, which are solely based on estimates of real-world payoff prospects and thus do not capture risk premia.

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