REFILE-CDOs resemble economic catastrophe bonds -Harvard

(Corrects paragraph two "writing" from "buying.")

By Jane Baird

LONDON, Oct 4 (Reuters) - Buyers of the top AAA tranches of collateralized debt obligations (CDOs) were not paid enough in the past for the true risk they took: that of an economic catastrophe bond, according to a Harvard Business School study.

Insurance companies, banks, pension funds and other big investors in these senior slices of CDOs could have got a lot more for their money by writing out-of-the-money puts on the U.S. S&P 500 index, another way to bet against economic catastrophe, Harvard professors Joshua Coval and Erik Stafford and doctoral student Jakub Jurek found.

What's more, they would not have been exposed to the liquidity crunch that has hit all CDO products since mid-July.

These investors now may demand higher spreads, which calls into question whether the economic model for cash CDOs works.

A CDO is a portfolio of credit risks that is divided into tranches. At the bottom, the riskiest tranche is exposed to the first few percent of losses from any credit in the portfolio. Default risk diminishes up the ladder to the top tranches, which lose after the others have gone under and so get AAA ratings.

Banks used CDOs to help sell billions of dollars of exposure to U.S. subprime mortgages. When subprime defaults rose, investors lost confidence in all CDOs as an asset class.

"Investors, perhaps for the wrong reasons, are now less interested in these products," Stafford said. "They think the ratings agencies got the probabilities wrong. We think that even if they got the probabilities (of default) right, they (CDOs) were totally mispriced."

Investors who bought the senior tranches relied on credit ratings to determine prices, he said. During the boom in the credit markets, banks packaged CDOs such that AAA-rated tranches would pay a few basis points more than AAA-rated bonds.

NAIVE OR NOT?

"A naive application of the law of one price says that a triple-A security should have the same yield (as any other triple-A security)," Stafford said.

"They (CDO arrangers) added value by giving you this yield advantage relative to the wrong benchmark," he said. "With the right benchmark, you are leaving a lot on the table for the risk you are bearing."

An out-of-the-money put, however, may not be an alternative for investors such as insurers and pension funds, whose mandates do not allow them to buy such instruments.

Vincent Matsui, an analyst with Fitch Ratings, argued investors in the top CDO tranches do have the technology and understanding of the different types of risk.