No economic catastrophe bonds

Abstract

The Financial Crisis of 2008 did much to discredit the idea of securitization. A recent argument has arisen concerning the idea that a senior tranche of a CDO should be treated as a security whose only risk exposure is to a true economic catastrophe, since anything less would be absorbed by the lower seniority tranches. This means that loss given default would be very large and also very systematic, so the highest rated tranches should be priced to pay larger risk premia than comparably rated single name bonds. Blöchlinger argues that this line of reasoning is wrong in theory, and empirically, observed yield spreads in the market do not support it either. Not only do the AAA tranches default only under the same extreme conditions as government bonds do, but they also benefit from the diversification within the CDO pool. The article demonstrates that this should make the most senior CDO tranches safer than (less diversified) single name bonds of the same rating. A key point in the proof is to recognize that, within the most senior tranche, the effect of diversification in the CDO pool is different for the average dollar of principal value than for the marginal dollar in that tranche (i.e., at the attachment point). Diversification in the pool increases the average value of the senior-most tranche, even though it lowers the value of the marginal dollar.