Valuing Toxic Assets: An Analysis of CDO Equity

Francis A. Longstaff, Brett Myers

NBER Working Paper No. 14871
Issued in April 2009
NBER Program(s):Asset Pricing

How does the market value complex structured-credit securities? This issue is central to understanding the current financial crisis and identifying effective policy measures. We study this issue from a novel perspective by contrasting the valuation of CDO equity with that of bank stocks. This is possible because both CDO equity and bank stock represent levered first-loss residual claims on an underlying portfolio of debt. There are strong similarities in the two types of equity investments. Using an extensive data set of CDX index tranche prices, we find that the discount rates applied by the market to bank and CDO equity are very comparable. In addition, a single factor explains more than 64 percent of the variation in bank and CDO equity returns. Although banks are presumably active credit-portfolio managers, we find that bank alphas are significantly negative during the sample period and comparable in magnitude to those of more-passively-managed CDO equity. Both banks and CDO equity display significant sensitivity to "shadow banking" factors such as counterparty credit risk, the availability of collateralized financing for debt securities, and the liquidity of the derivatives market. A key implication is that we may be able to value "toxic" assets using readily-available stock market information.

download in pdf format
   (330 K)

email paper

Machine-readable bibliographic record - MARC, RIS, BibTeX

Document Object Identifier (DOI): 10.3386/w14871

Users who downloaded this paper also downloaded* these:
Longstaff and Rajan w12210 An Empirical Analysis of the Pricing of Collateralized Debt Obligations
House and Masatlioglu w16145 Managing Markets for Toxic Assets
Fogel w14967 The Impact of the Asian Miracle on the Theory of Economic Growth
Benmelech and Dlugosz w14878 The Alchemy of CDO Credit Ratings
Franke and Krahnen Default Risk Sharing between Banks and Markets: The Contribution of Collateralized Debt Obligations
NBER Videos

National Bureau of Economic Research, 1050 Massachusetts Ave., Cambridge, MA 02138; 617-868-3900; email:

Contact Us