CDO and ABS Underperformance

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Abstract
Model risk partly explains the poor credit performance of certain sectors of the structured finance markets in 2001 and 2002: CDOs and aircraft, franchise loan, and mutual fund 12b-1 fee asset-backed securities. The common Monte Carlo simulations or other non-actuarial methods have inadequately addressed correlations of risk among assets within a pool. These tools also fall short in addressing the more subtle effects of time-varying correlations?correlations that change with the passage of time. Model risk is entirely real, if hard to measure, but it may be possible to correct or improve the analytic methods used in these troubled sectors. Some techniques here may show promise.

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