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

A bank holds a mezzanine tranche of an asset-backed security rated AA at issuance. During the subprime crisis, many such tranches were downgraded sharply even though the rating agencies' models had assumed modest losses. Which weakness in the rating process best explains the severity of these downgrades?

The best explanation is that rating models used historically low default rates and low correlation across mortgage pools. When house prices fell nationwide, defaults rose together, so losses reached mezzanine tranches that had been rated AA, causing severe downgrades.

  1. AModels relied on historically low and weakly correlated mortgage default rates that did not hold when house prices fell nationwideCorrect
  2. BModels assumed that all mortgage defaults were perfectly correlated across regions
  3. CRatings measured liquidity risk and market price volatility rather than credit loss
  4. DRatings were assigned only to equity tranches, leaving senior tranches unrated

Explanation

Ratings depended on models calibrated to a benign history in which regional house price declines offset each other, implying low default correlation. When prices fell nationally, defaults became highly correlated and losses hit mezzanine tranches. Assuming perfect correlation would have produced very conservative ratings, not overly generous ones.

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