Default Risk Sharing between Banks and Markets : The Contribution of Collateralized Debt Obligations

This paper contributes to the economics of financial institutions risk management by exploring how loan securitization affects their default risk, their systematic risk, and their stock prices. In a typical CDO transaction a bank retains through a first loss piece a very high proportion of the expected default losses, and transfers only the extreme losses to other market participants. The size of the first loss piece is largely driven by the average default probability of the securitized assets. If the bank sells loans in a true sale transaction, it may use the proceeds to to expand its loan business, thereby incurring more systematic risk. We find an increase of the banks' betas, but no significant stock price effect around the announcement of a CDO issue. Our results suggest a role for supervisory requirements in stabilizing the financial system, related to transparency of tranche allocation, and to regulatory treatment of senior tranches