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

A risk manager reviewing the lead-up to the subprime crisis notes that many mortgage-backed CDO tranches rated AAA were later heavily impaired. Which feature of the CDO structure best explains why the AAA ratings proved so fragile?

AAA CDO tranches proved fragile because their mezzanine collateral was driven by a common US housing factor, so defaults were far more correlated than rating models assumed. Diversification was overstated, and when house prices fell, losses reached the supposedly safe senior tranches.

  1. AThe underlying mezzanine tranches had highly correlated defaults tied to the same US housing market factor, so the diversification assumed by the rating models was overstatedCorrect
  2. BThe AAA tranches were always the first to absorb losses in the waterfall, so any default in the pool impaired them
  3. CThe collateral consisted mainly of government-guaranteed bonds whose guarantees were withdrawn
  4. DThe CDO notes were floating rate, so rising rates eliminated the excess spread in every tranche

Explanation

Senior tranches of CDOs of ABS were backed by mezzanine ABS tranches that all depended on the same US house price factor. Rating models assumed low correlation, so the probability of widespread losses was understated. Option B reverses the waterfall: senior tranches absorb losses last.

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