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

A risk committee is analyzing why a thin mezzanine ABS tranche was far more sensitive to a small rise in underlying mortgage default rates than a comparable senior tranche, and why a CDO squared amplified this. Which statement is most accurate?

Thin mezzanine tranches are leveraged exposures to pool losses because of the nonlinear call-spread-like payoff. Re-securitizing them concentrates risk on the same systematic factor, amplifying sensitivity and exposing the structure to large model and correlation error.

  1. AThin tranches have low leverage to pool losses, so a CDO built from them has lower systematic risk than the underlying pool
  2. BThin mezzanine tranches act as leveraged bets on pool losses, and re-securitizing them concentrates exposure to the same systematic factor, magnifying sensitivity and model errorCorrect
  3. CBecause tranche losses are linear in pool losses, re-securitization has no effect on sensitivity
  4. DRe-securitization reduces correlation because each tranche has a different rating

Explanation

A tranche's loss is a call-spread-like payoff on pool loss, so a thin tranche has high leverage to pool losses. Re-securitizing mezzanine tranches stacks the nonlinearity on a shared systematic factor, making outcomes highly sensitive to correlation and default assumptions. Linearity is false.

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