A Little Knowledge Is A Dangerous Thing: Model Specification, Data History, and CDO (Mis)Pricing∗

The revaluation of collateralized debt obligations (CDOs) plays a significant role in the ongoing 2007-2009 credit crisis. Starting in August 2007, a large amount of initially AAA rated CDO securities are substantially downgraded, some directly to junk grade. This paper explores two structural sources of CDO mispricing: modeling difficulty and data limitation. Simulating the frailty correlated default model of Duffie, Eckner, Horel, and Saita (2008), we show that CDO mis-pricing can be partly attributed to model misspecifications, as well as limited availability of historical data on CDO collateral assets. This simulation result is consistent with empirical evidence on historical performance of a sample of 279 CDOs. The frailty model estimated with adequate historical data would have reduced the amount of AAA rated CDO securities by 12% on average. The frailty model has predictive power for the subsequent downgrading of AAA rated CDO tranches. Our study addresses practical issues on financial innovations and provides guidance for corresponding risk management. ∗We thank for remarks from Andrew Carverhill, Wing Suen and seminar participants at the university of Hong Kong, 11th Bowles Symposium at Georgia State University, 19th Annual Derivative Securities and Risk Management Conference at Federal Deposit Insurance Corporation (FDIC). We are especially grateful to Andreas Eckner for providing the filtered frailty factor. †Authors are at School of Economic and Finance, the University of Hong Kong. Dan Luo can be reached by Email: [email protected]. Dragon Tang can be reached by Email: [email protected] and Phone: (+852) 22194321. Sarah Qian Wang can be reached by Email: [email protected]. A Little Knowledge Is A Dangerous Thing: Model Specification, Data History, and CDO (Mis)Pricing