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

A cash CDO of 100 million holds BBB-rated tranches of subprime RMBS. Its senior tranche is rated AAA. During a housing downturn, the senior CDO tranche suffers far larger losses than AAA corporate bonds. What is the best explanation?

The senior CDO tranche lost heavily because the underlying mezzanine RMBS tranches were concentrated in the same housing risk and highly correlated. A systematic shock eroded the subordination, and the ratings had assumed far more diversification than actually existed.

  1. AUnderlying tranches were highly correlated and concentrated in the same systematic housing risk, so the diversification assumed in the rating failedCorrect
  2. BAAA ratings apply only to cash flow and not to credit risk
  3. CCDO senior tranches have no subordination
  4. DThe underlying assets were short-dated and so had no default risk

Explanation

Mezzanine RMBS tranches all depended on the same housing market. Their defaults were highly correlated, so a systematic shock wiped out the subordination under the CDO senior tranche. Ratings had assumed lower correlation. Subordination existed, so option three is wrong, and ratings do measure credit risk.

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