Collateralized debt obligations (CDOs) are structured fixed income securities whose payouts depend on the performance of pools of collateral comprised of corporate bonds or loans or other structured securities which are themselves backed by underlying collateral pools. Recently, large numbers of highly-rated CDO notes backed by mortgage securities have experienced dramatic credit rating downgrades and a few have declared defaults. As investors have become increasingly concerned about the credit risk embedded in complex structured products, demand for CDOsandother structured products has plummeted, creating liquidity and credit challenges for some financial institutions.
Rating agencies that make a business of assessing the credit quality of fixed income securities have been criticized for issuing ratings for CDOs and other structured products that were too optimistic or did not capture the full range of risks associated with these securities. Perhaps most notably, the President's Working Group on Financial Markets (2008), a committee of financial regulators chaired by Treasury Secretary Henry Paulson, has concluded that "[c]reditrating agencies contributed significantly to the recent market turmoil by underestimating the credit risk ofsubprime residential-mortgage-backed securities and other structured credit products, notably [asset-backed] CDOs."
Going forward, regulators and somepolicymakers have called upon rating agencies to treat structured credit products differently from other types of fixed income securities such as corporate bonds. For example, the President's Working Group has asked rating agencies to "make changes to the credit rating process that could clearly differentiate ratings for structured products from ratings for corporate and municipal securities" and "work with investors to provide the information investors need to make informed decisions about risk, including measures of the uncertainty associated with ratings and of potential ratings volatility."
Implicit in these recommendations is the assumption that credit ratings may not be directly comparable across different types of debt securities, and in particular, that ratings for structured securities may not be as informative as those for corporate or municipal bonds.
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Parameter Uncertainty and the Credit Risk of Collateralized Debt Obligations
