The performance of a security backed by a pool of loans is affected by default correlation, and not only the probability of default. I imply default correlation from the market price of collateralized mortgage obligations. Implied correlations are informative about subsequent bond downgrades, but this information content depends on the quality of documentation on the underlying loans. Correlations implied from junior tranches are no more informative than those of AAA tranches for "low-doc" deals, and the latter no less informative than the former for "full-doc" deals. Errors in computing default correlations were thus not driven by AAA investors but rather by "low-doc" investors. Moreover, regulation aiming for market transparency through better loan documentation can be more effective than the one aiming to curb the principal-agent problem.
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