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FRM Part I · FRM Exam Part I · Anatomy of the Great Financial Crisis of 2007-2009

A CDO is built from BBB-rated tranches of subprime mortgage-backed securities, and its senior tranches received AAA ratings. Which weakness in the rating approach best explains why these AAA tranches suffered large losses in 2007-2008?

The AAA ratings on CDO senior tranches assumed low default correlation among underlying mortgages. A nationwide decline in house prices caused defaults to cluster, so losses hit mezzanine collateral heavily and spread to senior tranches that were supposedly safe from diversification.

  1. AThe ratings assumed the underlying mortgage defaults had low correlation, ignoring that a nationwide fall in house prices would hit all mortgages simultaneouslyCorrect
  2. BThe ratings ignored the coupons paid by the mezzanine tranches
  3. CThe ratings assumed that all mortgages would default on the same date
  4. DThe ratings were based on market prices rather than on models

Explanation

Rating models relied on limited historical data and understated default correlation, especially systematic exposure to a national house price decline. When prices fell, defaults clustered, wiping out mezzanine collateral and impairing senior CDO tranches. The other options misdescribe the models.

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