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FRM Part I · FRM Exam Part I · Anatomy of the Great Financial Crisis of 2007-2009

A bank holds a AAA-rated senior tranche of a CDO backed by subprime mortgage securities. In 2007, house prices fall and the tranche is downgraded sharply within months. Which observation about structured product ratings best explains the severity of the downgrade relative to a similarly rated AAA corporate bond?

Structured tranches are highly sensitive to systematic risk. A modest adverse move in the common factor, such as house prices, can erode credit enhancement and sharply raise tranche losses, causing large downgrades. A same-rated corporate bond lacks this concentrated systematic exposure and migrates far more gradually.

  1. ACorporate bonds have higher default correlation than structured tranches, so they are downgraded less
  2. BStructured tranches are highly sensitive to systematic risk, so a modest change in the common factor can cause large changes in tranche losses and ratingsCorrect
  3. CStructured tranches have no exposure to market-wide factors
  4. DRating agencies rate structured tranches on a different scale that is not comparable to corporate ratings

Explanation

A senior structured tranche is a leveraged claim on the systematic factor (here, house prices). A modest rise in the factor's adverse movement or in default correlation can wipe out the credit enhancement, producing large rating migrations. A same-rated corporate bond is mainly exposed to idiosyncratic risk and migrates more gradually. The scale was the same, so the last option is wrong.

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