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

A structured finance investor relies on external ratings for a portfolio of ABS CDO tranches. Based on lessons from the subprime crisis, which risk management response is most appropriate?

The investor should supplement ratings with independent analysis of collateral quality, correlation assumptions and model risk. The crisis showed that structured product ratings rested on limited data and optimistic assumptions, and that mechanical reliance on them led to large unexpected losses and sharp downgrades.

  1. ASupplement ratings with independent analysis of the underlying collateral, correlation assumptions and model uncertaintyCorrect
  2. BTreat all AAA tranches as equivalent to AAA sovereign debt for capital purposes
  3. CRely on ratings alone because rating agencies have full information on the collateral
  4. DIgnore tranche subordination since ratings already reflect it

Explanation

The crisis showed ratings relied on models with weak data and low-correlation assumptions, and that structured product ratings could migrate sharply. Investors should perform their own due diligence rather than depend mechanically on ratings. The other choices reflect the overreliance that caused losses.

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