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The Journal of Structured Finance

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Article

Inflated Ratings on Pre-Crisis CDOs: A Deeper Look

Mark Adelson
The Journal of Structured Finance Summer 2016, 22 (2) 37-47; DOI: https://doi.org/10.3905/jsf.2016.22.2.037
Mark Adelson
is an independent consultant in New York, NY and the editor of .
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  • For correspondence: markadelson@nyc.rr.com
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Abstract

Methodologies for analyzing and rating collateralized debt obligations (CDOs) backed by structured finance securities (SF-CDOs) were significantly flawed before the 2008 financial crisis. Two key issues were model risk and the absence of calibration to historical benchmarks. Although financial literature highlighted model risk as a potential problem starting in the mid-1990s, market participants— including the rating agencies—failed to properly address the issue. That partly explains why SF-CDOs that performed horribly during and after the financial crisis received high credit ratings before the crisis. With the 2009 update to its corporate CDO rating methodology, Standard & Poor’s was the first rating agency to embrace measures designed to mitigate model risk. Those measures included calibrating the methodology’s simulation model against external benchmarks and adding outside-the-model tests. Today, with the benefit of experience from the crisis, CDO investors should be wary of relying on any analytic methodology that does not specifically address model risk.

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The Journal of Structured Finance: 22 (2)
The Journal of Structured Finance
Vol. 22, Issue 2
Summer 2016
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Inflated Ratings on Pre-Crisis CDOs: A Deeper Look
Mark Adelson
The Journal of Structured Finance Jul 2016, 22 (2) 37-47; DOI: 10.3905/jsf.2016.22.2.037

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Inflated Ratings on Pre-Crisis CDOs: A Deeper Look
Mark Adelson
The Journal of Structured Finance Jul 2016, 22 (2) 37-47; DOI: 10.3905/jsf.2016.22.2.037
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  • Article
    • Abstract
    • WEAK PERFORMANCE OF SF-CDOs IN THE FINANCIAL CRISIS
    • CHARACTERISTICS OF A WELL-CRAFTED RATING METHODOLOGY
    • EVOLUTION OF S&P’S METHODOLOGY FOR RATING SF-CDOs
    • A CLOSER LOOK AT MODEL RISK AND CALIBRATION IN THE SF-CDO RATING METHODOLOGY
    • CONCLUSION
    • ENDNOTE
    • REFERENCES
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