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

A bank holds a senior AAA-rated tranche of a mortgage-backed CDO squared whose collateral consists of mezzanine tranches of subprime RMBS. Before the subprime crisis, the bank treated the tranche as having the same low risk as a AAA corporate bond. Which feature most directly explains why this treatment understated the risk?

Senior tranches of structured products are highly sensitive to systematic risk. Because mortgage losses are correlated through house prices, a modest rise in losses can exhaust the subordination beneath a AAA tranche, so it was far riskier than a similarly rated corporate bond.

  1. AAAA structured tranches have the same default correlation profile as AAA corporate bonds, so the ratings are directly comparable
  2. BStructured finance tranches are highly sensitive to systematic risk, so a small rise in the underlying mortgage loss rate can wipe out a AAA tranche in a way that is unlikely for a corporate bondCorrect
  3. CAAA tranches in CDOs always carry a higher coupon than AAA corporate bonds, which compensates for the extra risk
  4. DCorporate bonds have greater exposure to interest rate risk than structured tranches, so they are less comparable

Explanation

Structured tranches, particularly those backed by mezzanine ABS, are leveraged exposures to systematic risk. Because the underlying loans are highly correlated through house prices, a moderate rise in losses can exhaust subordination and impair even senior tranches. A same-rating corporate bond lacks this cliff-like sensitivity. The coupon statement is not the explanation of the mismeasurement.

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