Risk Latte - Broken Hearts and CDOs

Broken Hearts and CDOs

Rahul Bhattacharya
May 08, 2006

In May 2005, quite a few hearts were broken. Many investors, mostly hedge funds, lost a lot of money on CDOs of GM and Ford Motors. By some estimates the losses have been estimated to be around US$1 billion. Yes, that can indeed break a lot of hearts.

In fact CDOs (Collateralized Debt Obligations) are not very easy to understand and their pricing is based on complex mathematical models. Experts from the academia and the banking industry are quite perplexed by the plethora of pricing models that have been developed so far. However, and ironically, one model which has come to dominate the financial industry in the last five years is based on an actuarial model which itself is predicated on a simple lifestyle observation of human beings and is known as the "broken heart" syndrome. Simply put this syndrome states that there is a high probability of an early death of an individual after the death of his or her spouse. There is strong empirical evidence, at least in the UK and Europe that supports the dependence of mortality on married couples. For example consider this study: using a dataset consisting of 4,486 55-year-old widowers, Parkes et al. (1969) showed that there is a 40% increase in mortality among the widowers during the first few months after the death of their wives. Actually, the phenomenon can be generalized under a broader model where mortality of pairs of individuals (twins, family, children, etc.) are analyzed.

David Li's famous paper in 2000 made use of this concept in modelling default times of companies (names) and thus pricing CDOs. To quote him: "Default is like the death of a company, so we should model this the same way we model human life." Thus if a company in a certain industry defaults there is a high probability that a very similar company (call it a "corporate twin" or a "corporate spouse") will also default soon–within a certain period from the default of the first company.

The million dollar question, albeit a morbid one, is what will really break a modern day hedge fund manager's heart: tens of millions of dollars in losses in CDOs or the death of his spouse?

Reference: Wall Street Journal Online article (September 12, 2005), Understanding Relationships using Copulas by Edward W. Frees and Emiliano A. Valdez

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