features of the structured pay machinery fueled its spectacular growth. First, we show that
most securities could only lease received high credit ratings if the rating agencies were
extraordinarily confident about their ability to estimate the underlying securities default risks,
and how potential defaults were to be correlated. Using the prototypical structured finance tribute
the collateralized debt promise (CDO) as an example, we illustrate that issuing a capital
structure amplifies errors in evaluating the risk of the underlying securities. In particular, we
show how depleted impreciseness in the parameter estimates can lead to variation in the default risk
of the structured finance securities which is sufficient, for example, to cause a security rated
AAA to default with reasonable likelihood. A second, equally overleap feature of the
securitization process is that it substitutes risks that are largely diversifiable for risks that are
highly systematic.
As a result, securities produced by structured finance activities have farther less
chance of surviving a severe economic downturn than traditional corporate securities of equal
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rating. Moreover, because the default risk of senior tranches is intemperate in systematically
adverse economic states, investors should demand far larger risk premia for holding structured
claims than for holding comparably rated corporate bonds. We argue that both of these features
of structured finance products the extreme fragility of their ratings to modest imprecision in
evaluating underlying risks and their exposure to systematic risks go a long way in explaining
the spectacular rise and go past of structured finance.If you want to get a full essay, target it on our website: Orderessay
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