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The Economics of Structured Finance

The Journal of economic perspectives, 2009, Vol.23 (1), p.3-26 [Peer Reviewed Journal]

Copyright 2009 American Economic Association ;Copyright American Economic Association Winter 2009 ;ISSN: 0895-3309 ;EISSN: 1944-7965 ;DOI: 10.1257/jep.23.1.3

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Title:
The Economics of Structured Finance
Author: Coval, Joshua ; Jurek, Jakub ; Stafford, Erik
Subjects: Balance sheets ; Bond default ; Bond ratings ; Capital structure ; Collateral ; Collateralized debt obligations ; Corporate bonds ; Credit ratings ; Credit risk ; Debt ; Default ; Derivatives ; Finance ; Financial assets ; Financial economics ; Financial engineering ; Financial risks ; Financial securities ; Financial services ; Investment pools ; Investment risk ; Investors ; Loan defaults ; Macroeconomics ; Mortgage loans ; Rating services ; Risk exposure ; Risk management ; Securitization ; Studies ; Symposium: Early Stages of the Credit Crunch
Is Part Of: The Journal of economic perspectives, 2009, Vol.23 (1), p.3-26
Description: This paper investigates the spectacular rise and fall of structured finance. The essence of structured finance activities is the pooling of economic assets like loans, bonds, and mortgages, and the subsequent issuance of a prioritized capital structure of claims, known as tranches, against these collateral pools. As a result of the prioritization scheme used in structuring claims, many of the manufactured tranches are far safer than the average asset in the underlying pool. This ability of structured finance to repackage risks and to create “safe” assets from otherwise risky collateral led to a dramatic expansion in the issuance of structured securities, most of which were viewed by investors to be virtually risk-free and certified as such by the rating agencies. At the core of the recent financial market crisis has been the discovery that these securities are actually far riskier than originally advertised. We examine how the process of securitization allowed trillions of dollars of risky assets to be transformed into securities that were widely considered to be safe. We highlight two features of structured finance products—the extreme fragility of their ratings to modest imprecision in evaluating underlying risks, and their exposure to systematic risks—that go a long way in explaining the spectacular rise and fall of structured finance. We conclude with an assessment of what went wrong and the relative importance of rating agency errors, investor credulity, and perverse incentives and suspect behavior on the part of issuers, rating agencies, and borrowers.
Publisher: Nashville: American Economic Association
Language: English
Identifier: ISSN: 0895-3309
EISSN: 1944-7965
DOI: 10.1257/jep.23.1.3
Source: AUTh Library subscriptions: ProQuest Central

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The Economics of Structured Finance

Copyright 2009 American Economic Association ;Copyright American Economic Association Winter 2009 ;ISSN: 0895-3309 ;EISSN: 1944-7965 ;DOI: 10.1257/jep.23.1.3

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