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FRM Part II · FRM Exam Part II · Structured Credit Risk

A bank considers buying a senior tranche of a CDO of mezzanine ABS tranches. Compared with a senior tranche of a direct loan-pool securitization with the same rating, which feature is the main reason the re-securitization tranche is riskier?

The re-securitization senior tranche is riskier mainly because its underlying mezzanine tranches are thin, leveraged claims driven by the same systematic factor. Their losses are highly correlated, so one adverse shock can hit many at once, making the senior rating very sensitive to correlation and model assumptions.

  1. AIts underlying assets are mostly in a single currency
  2. BIts underlying mezzanine tranches are highly exposed to the same systematic factor, so ratings are highly sensitive to correlation and model assumptionsCorrect
  3. CIt has no subordination
  4. DIt pays a floating coupon while the pool pays fixed

Explanation

Mezzanine tranches are thin and levered claims on the same systematic risk, so their losses are highly correlated, and a small adverse shift in the systematic factor can wipe out many underlying tranches at once. The senior tranche of such a CDO therefore has far greater model and correlation sensitivity than a tranche on a diversified loan pool. Re-securitizations do have subordination, and coupon type or currency is not the key driver.

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