A free lunch and the credit crunch

Monoline insurers act as triple-A guarantors of the senior risks in structured finance. A purchaser of credit insurance or protection from a monoline may argue that they take only a small amount of the counterparty risk that is a common side-effect of trading over-the-counter derivatives products. However, in this article Jon Gregory argues that credit insurance purchased in this fashion carries significant counterparty risk and from a quantitative point of view has little or no value

The structured credit market has grown rapidly in recent years and correlation is now traded across the capital structure, from risky equity tranches to senior tranches that are triple-A rated.1 Consider the most senior tranche of the CDX IG (North American Investment Grade Index), which references losses in the 30-100% range on the underlying portfolio of 125 investment-grade credits. An investor taking the risk on this tranche can potentially survive default of half the underlying portfolio

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