SOURCE: Kamakura Corporation

January 16, 2008 15:13 ET

CDO Correlation: Reversal of Fortune

New Kamakura Study Proves Common CDO Assumptions Can Lead to Serious Valuation Errors

HONOLULU, HI--(Marketwire - January 16, 2008) - Kamakura Corporation released an important research paper on collateralized debt valuation that proves a common market assumption about correlations can lead to dramatically incorrect CDO valuations. The study, authored by Kamakura's Professor Robert A. Jarrow and Dr. Donald R. van Deventer, is a companion piece to the Kamakura CDO study released in December. The new paper, "Synthetic CDO Equity: Long or Short Correlation Risk?" addresses the common CDO market assumption that an increase in the correlation of defaults increases the value of the equity tranches of CDOs. Since banks themselves are essentially large CDOs, the dramatic decline of financial institutions' stock prices in the current credit crisis shows that the view that "equity is long correlation" can be dramatically wrong. The authors show in a series of examples that the value of equity tranches of synthetic CDOs can either rise or fall, depending on the nature of the modeling techniques employed.

"The former Chief Executive Officers of Citigroup and Merrill Lynch certainly understand now that an increase in correlated defaults is bad for the equity holders," said Warren Sherman, Kamakura President and Chief Operating Officer, "but CDO market participants have long held the opposite view when it comes to the equity tranche of the 'mini-bank' called a CDO. This new study shows that an increase in correlated defaults can be either good or bad for the equity tranche. It is absolutely critical from a corporate governance and risk management point of view that the true risk of the CDO tranche owner is measured correctly. In the current environment, modeling techniques that restrict the user to a set of unrealistic assumptions pose a serious danger to both the institutions who own the CDO and to the analysts that employ them, as job losses all over Wall Street in recent weeks have proven. This paper shines a bright light on common practice and has huge implications for the way forward which produces maximum accuracy."

The Jarrow and van Deventer paper, dated January 15, is available upon request from Mr. Warren Sherman, and 1-201-600-7542. The paper uses both logic and simulation to demonstrate that the impact of higher correlation can have either a positive or negative impact on the value of equity tranches. A companion piece, "CDO Valuation: Fact and Fiction," by Robert A. Jarrow, Li Li, Mark Mesler and Donald R. van Deventer was released on December 19, 2007 and is forthcoming in a book from RISK Publications.

About Kamakura Corporation

Founded in 1990, Kamakura Corporation is a leading provider of risk management information, processing and software. Kamakura has been a provider of daily default probabilities and default correlations for listed companies since November 2002. Kamakura launched its collateralized debt obligation (CDO) pricing service KRIS-CDO in April 2007. Kamakura is also the first company in the world to develop and install a fully integrated enterprise risk management system that analyzes credit risk, market risk, asset and liability management, transfer pricing, and capital allocation. Kamakura has served more than 160 clients ranging in size from $3 billion in assets to $1.6 trillion in assets. Kamakura's risk management products are currently used in 25 countries, including the United States, Canada, Germany, the Netherlands, France, Switzerland, the United Kingdom, Russia, Eastern Europe, the Middle East, Africa, Australia, Japan, China, Korea and many other countries in Asia.

Kamakura has worldwide distribution alliances with IPS-Sendero ( Unisys (, making Kamakura products available in almost every major city around the globe.

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