Esoteric structured debt investments, such as collateralized debt obligations, have been blamed for much of the credit crisis that started last summer. Like wildfire, the instruments' problems spread through other parts of the credit markets.
One paper, Common Failings: How Corporate Defaults Are Correlated, is drawing attention among institutional investors because it lays bare how such contagion becomes widespread when default events failure to service the debt or repay the principal occur, as was the case with CDOs.
Once defaults start happening, they induce a domino effect. This paper produced the first econometric technique that conclusively showed this domino effect exists, said Sanjiv Das, professor of finance at the Santa Clara University's Leavey School of Business, Santa Clara, Calif., who authored the paper along with Darrell Duffie, professor of finance, on leave of absence from Stanford University, Palo Alto, Calif.; Nikunj Kapadia, associate director at the Center for International Securities and Derivatives Markets at the University of Massachusetts, Amherst; and Leandro Saita, Ph.D. candidate at the Stanford Graduate School of Business.
The paper did not single out individual causes for the increase in corporate defaults but found a clustering pattern where various factors converge toward the outcome of a greater number of defaults.
The study won the Western Finance Association's Caesarea Center Award for best paper on risk management in 2005.
Mr. Das said Wall Street models had not always accounted for the contagion or domino effect when pricing CDOs or other structured debt investments.
Defaults naturally jump when the economy goes south, but the contagion effect occurs when bonds that were not necessarily exposed to the same macroeconomic factors start losing value too. Since last summer, this contagion has been apparent in the widening spreads across many debt markets.
Mebane Faber, managing director and portfolio manager at Cambria Investment Management Inc., El Segundo, Calif., noted the importance of contagion as a prominent feature of the storm that engulfed the quant managers' strategies last summer.
Now that everyone has access to the same data and cheap computing, they are able to mine the historical data to find the same factors that are predictive of future returns. The problem here is that there will be considerable herding. Add on the hubris and leverage associated with many of these portfolios, and even a small dislocation can cause havoc, said Mr. Faber.Isabelle Clary