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

A mezzanine tranche of a subprime RMBS was rated BBB and was repackaged with other BBB tranches into a CDO, whose senior tranche was rated AAA. Why did this resecuritization amplify losses in the crisis?

The CDO collateral was made of mezzanine tranches whose losses were highly correlated through the common housing factor. A systematic house price fall wiped out these thin tranches together, so even AAA-rated CDO senior tranches suffered large losses.

  1. AMezzanine tranches are exempt from losses until the equity tranche is fully repaid, so diversification was perfect
  2. BThe CDO collateral consisted of tranches whose losses were highly correlated, so the AAA senior CDO tranche was far more sensitive to a systematic housing decline than its rating impliedCorrect
  3. CThe AAA tranche had a lower credit spread than government bonds, so investors sold it
  4. DResecuritization eliminated exposure to the underlying mortgages, leaving only interest rate risk

Explanation

Mezzanine tranches from different pools were all exposed to the same systematic factor, U.S. house prices. Diversification was therefore illusory, and the thin BBB layers were wiped out together, impairing even senior CDO tranches. The other options misstate the structure.

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