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Article

CDO Squareds: The Case of Subprime Mortgages

Donald R. Chambers, Michael A. Kelly, Qin Lu, Adam Biesenbach, Angela King, Kuni Natsuki and Qi Sun
The Journal of Structured Finance Summer 2011, 17 (2) 96-113; DOI: https://doi.org/10.3905/jsf.2011.17.2.096
Donald R. Chambers
is Walter E. Hanson/KPMG Professor of Business and Finance at Lafayette College in Easton, PA.
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  • For correspondence: chambers@lafayette.edu
Michael A. Kelly
is an assistant professor of finance at Lafayette College in Easton, PA.
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  • For correspondence: kellyma@lafayette.edu
Qin Lu
is an associate professor of mathematics at Lafayette College in Easton, PA.
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  • For correspondence: luq@lafayette.edu
Adam Biesenbach
is a former NSF REU Fund-supported undergraduate student at Lafayette College and is now with the Federal Reserve Bank of New York in New York, NY.
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  • For correspondence: adam.biesenbach@ny.frb.org
Angela King
is a former NSF REU Fund-supported undergraduate student at Lafayette College and is now a Ph.D. student in the Operations Research Center at the Massachusetts Institute of Technology in Cambridge, MA.
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  • For correspondence: aking10@mit.edu
Kuni Natsuki
is a former NSF REU Fund-supported undergraduate student at Lafayette College and is now in San Jose, CA.
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  • For correspondence: Kuni_Natsuki@brown.edu
Qi Sun
is an undergraduate student at Lafayette College in Easton PA.
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  • For correspondence: qiqiqisun@gmail.com
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Abstract

Investment in residential subprime mortgages through structured products was at the heart of the financial crisis that began in 2007. Perhaps the most toxic such product was the CDO-squared. CDO-squareds are CDOs (collateralized debt obligations) with tranches of other CDOs serving as their collateral pool. CDO-squareds on mortgage-backed securities (ABS-CDOs) issued vast quantities of AAA rated securities that quickly fell to market values of a few cents on the dollar. This article examines ABS-CDOs with two primary purposes. First, it provides an intuitive explanation of ABS-CDOs, including their characteristics, risks, and models. Second, it performs a comprehensive sensitivity analysis of the AAA senior tranche width with respect to various parameters based on the Hull and White model of mortgage-backed securities. The authors find that ABSCDO senior tranche widths were unreasonable prior to the financial collapse that began in 2007, and they attribute the associated rating errors with the non-linearity, hyper-sensitivity, and complexity of the risks of the products with respect to their underlying parameters. Simply put, there is no reliable basis on which accurate measurements of risk can be made using existing data and theory.

  • © 2011 Institutional Investor, Inc.
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The Journal of Structured Finance: 17 (2)
The Journal of Structured Finance
Vol. 17, Issue 2
Summer 2011
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CDO Squareds: The Case of Subprime Mortgages
Donald R. Chambers, Michael A. Kelly, Qin Lu, Adam Biesenbach, Angela King, Kuni Natsuki, Qi Sun
The Journal of Structured Finance Jul 2011, 17 (2) 96-113; DOI: 10.3905/jsf.2011.17.2.096

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CDO Squareds: The Case of Subprime Mortgages
Donald R. Chambers, Michael A. Kelly, Qin Lu, Adam Biesenbach, Angela King, Kuni Natsuki, Qi Sun
The Journal of Structured Finance Jul 2011, 17 (2) 96-113; DOI: 10.3905/jsf.2011.17.2.096
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  • Article
    • Abstract
    • THE ECONOMICS OF SUBPRIME MORTGAGES
    • THE FIRST LEVEL OF STUCTURING: CDOs AND RMBSs
    • BACKGROUND ON ABS-CDOs
    • AN EXAMPLE OF AN ABS-CDO
    • THE DRIVERS OF ABS-CDO LOSSES
    • PARAMETERS FOR MODELING CDOs
    • MODELING AAA TRANCHE WIDTHS FOR ABS-CDOs
    • RESULTS AND ANALYSIS
    • SUMMARY AND CONCLUSIONS
    • APPENDIX
    • ENDNOTES
    • REFERENCES
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  • PDF (Subscribers Only)

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