The Role of the Constant Recovery Assumption in the Subprime Bubble

Abstract

Securitization of mortgages is believed to have contributed to the recent boom and bust in real estate. In particular, structured products with wide tranches of AAA-rated derivative securities are retrospectively vilified.A key issue has been to understand how such large tranches of securities could have been viewed as safe despite the apparent high risks of the underlying mortgages. In this article, the authors analyze the complex models and the models’parameters to estimate the risks of the structured securities.They find that the models themselves, not the inputted parameters, such as expected default rates and correlations, were responsible for inappropriate ratings. In particular, they find that the assumption of a constant recovery rate generated generous ratings for large tranches of securities even with reasonable parameter estimates.