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

A CDO is backed by mezzanine tranches of subprime RMBS, each rated BBB. A risk manager finds that the CDO's senior tranche was rated AAA based on an assumption of low default correlation among the underlying RMBS. In a housing downturn, which outcome is most consistent with the lessons of the subprime crisis?

Correlation among the underlying RMBS tranches rose because they shared the same housing and underwriting drivers. Losses therefore clustered, and the CDO senior tranche suffered much more than the low-correlation model assumed. The apparent diversification of the pool was largely illusory.

  1. ACorrelation among the underlying tranches rises, so losses are concentrated and the CDO senior tranche is hit far harder than the model impliedCorrect
  2. BDiversification across many RMBS tranches eliminates losses for the CDO senior tranche
  3. CCorrelation falls, so the CDO equity tranche absorbs all losses
  4. DThe ratings stay stable because the underlying tranches are all BBB

Explanation

The underlying RMBS shared exposure to the same US housing and underwriting factors, so their defaults were highly correlated in the downturn. Underestimating that correlation overstated the diversification benefit and understated senior CDO losses. Falling correlation is the opposite of what occurred.

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