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FRM Part II · FRM Exam Part II · An Introduction to Securitisation

A bank analyst reviews a mortgage-backed securitisation structured with senior, mezzanine and equity tranches. Before the subprime crisis, many investors treated the AAA-rated senior tranche as having the same risk as a AAA corporate bond. Which feature of the senior tranche most directly makes this assumption flawed?

The flaw is that a senior tranche's risk depends heavily on systematic factors and correlation. It looks safe until widespread pool defaults occur, then losses can arrive abruptly. A AAA corporate bond has a different risk profile, so equating the two ignores tranche leverage and correlation sensitivity.

  1. AIts default risk is highly sensitive to systematic factors, so it can lose value abruptly when asset correlation risesCorrect
  2. BIts rating is based only on the issuer's credit spread, which is unrelated to the pool
  3. CIts cash flows come from a single borrower, so idiosyncratic risk dominates
  4. DIts coupon is always floating, so it carries no interest rate risk

Explanation

Senior tranches are exposed to systematic risk because losses only reach them when the collateral pool suffers widespread defaults. Their loss distribution is therefore skewed and cliff-like, unlike a similarly rated corporate bond. The other options misdescribe how tranches and ratings work.

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