Default Risk Sharing Between Banks and Markets: The Contribution of Collateralized Loan Obligations

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Default Risk Sharing Between Banks and Markets: The Contribution of Collateralized Loan Obligations

by Günter Franke of the Konstanz Universitaet, and
Jan Pieter Krahnen of the Goethe-Universitaet and CEPR

October 10, 2004

Abstract: This paper contributes to the economics of financial institutions risk management by exploring how loan securitization affects their default risk, their systematic risk, and their stock prices. In a typical CDO transaction a bank retains a very high proportion of the expected default losses, and transfers only the extreme losses to other market participants. This enables the bank to expand its loan business, thereby incurring more systematic risk. It also raises its beta. While we do not find a significant stock price effect around the announcement of a CDO issue, in line with the irrelevance proposition, we do find some cross sectional variations related to issue characteristics.

JEL Classification: D82, G21, D74.

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