Debt correlations in the wake of the financial crisis: What are appropriate default correlations for structured products?

This paper proposes several frameworks to estimate the appropriate default correlations for structured products, each of which jointly considers the role of co-movements in modeled risk characteristics and unmodeled systematic risk, or 'frailty.' We contrast our estimates with credit rating agencies' default correlation assumptions, which were only 0.01 for Collateralized Loan Obligations (CLOs) pre-crisis and have increased to 0.03 post-crisis. In contrast, the joint consideration of observable risk factors and frailty leads to substantially higher estimates of 0.12. We show that this translates into CLOs with credit risk understated by 26%, suggesting caution for the post-crisis structured finance market.