Intrinsic risks and structuring risks of structured finance

Abstract

The debate about the role of structured finance securities like ABS or CDOs in the subprime crisis is representative for a gap in the theory of securitization which in the past was focused on valuation and hedging issues. The area of real-world credit risk analysis which is the foundation for risk and capital management was largely neglected. In this paper we examine structuring risks as well as intrinsic credit risks of structured securitizations from a theoretical perspective. We derive analytical results for the high systematic risk factor sensitivity of tranches, the consequences of flawed pool risk parameters and risk factor forecasts on the capital structure and its risks, as well as the specific role of point-in-time and through-the-cycle ratings. Contrary to other studies we treat the capital structure not as exogenous but rather as endogenous quantity. Our results reveal several potentials for improvement in terms of quantitative risk management.