Tranching and Rating

In this paper we analyze the source and magnitude of marketing gains from selling structured debtsecurities at yields that reflect only their credit ratings, or specifically at yields on equivalently ratedcorporate bonds. We distinguish between credit ratings that are based on probabilities of defaultand ratings that are based on expected default losses. We show that subdividing a bond issuedagainst given collateral into subordinated tranches can yield significant profits under thehypothesized pricing system. Increasing the systematic risk or reducing the total risk of the bondcollateral increases the profits further....