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FRM Part I · FRM Exam Part I · Credit Risk Transfer Mechanisms

A bank holds a securitization with a senior tranche rated AAA that is backed by a pool of mortgages whose defaults are highly correlated through a common housing-price factor. Which statement best explains why the senior tranche is more sensitive to an increase in default correlation than the pool itself?

Higher default correlation fattens the tail of the pool loss distribution. Expected pool loss barely changes, but the chance of very large losses rises, which can exhaust the subordination protecting the senior tranche and so makes it far more sensitive than the pool average suggests.

  1. AHigher correlation fattens the tail of the pool loss distribution, raising the probability of losses large enough to breach subordination below the senior trancheCorrect
  2. BHigher correlation raises the expected pool loss, which directly raises the senior tranche's expected loss one-for-one
  3. CHigher correlation reduces the equity tranche's loss probability, shifting losses upward to senior holders
  4. DHigher correlation lowers recovery rates in proportion to the tranche's seniority

Explanation

Correlation leaves expected pool loss roughly unchanged but increases the probability of extreme joint defaults, which is the region that exhausts subordination and hits senior tranches. Senior tranches therefore gain risk while equity tranches often become less risky. Expected pool loss is not changed by correlation, so the second option is wrong.

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