Kamakura Corporation released a research paper on collateralized debt valuation that says a common market assumption about correlations can lead to dramatically incorrect CDO valuations.
The study, authored by Kamakura’s Prof. Robert A. Jarrow and Dr. Donald R. van Deventer, is a companion piece to the Kamakura CDO study released in December. The new paper, “Synthetic CDO Equity: Long or Short Correlation Risk?,” addresses the common CDO market assumption that an increase in the correlation of defaults increases the value of the equity tranches of CDOs. Because banks themselves are essentially large CDOs, the dramatic decline of financial institutions stock prices in the current credit crisis shows that the view that “equity is long correlation” can be dramatically wrong, the paper says. The authors attests in a series of examples that the value of equity tranches of synthetic CDOs can either rise or fall, depending on the nature of the modeling techniques employed.
“The former chief executive officers of Citigroup and Merrill Lynch certainly understand now that an increase in correlated defaults is bad for the equity holders,” says Warren Sherman, Kamakura president and chief operating officer, “but CDO market participants have long held the opposite view when it comes to the equity tranche of the ‘mini-bank’ called a CDO. This new study shows that an increase in correlated defaults can be either good or bad for the equity tranche. It is absolutely critical from a corporate governance and risk management point of view that the true risk of the CDO tranche owner is measured correctly. In the current environment, modeling techniques that restrict the user to a set of unrealistic assumptions pose a serious danger to both the institutions who own the CDO and to the analysts that employ them, as job losses all over Wall Street in recent weeks have proven. This paper shines a bright light on common practice and has huge implications for the way forward which produces maximum accuracy.”