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

A structured finance rating committee notes that a mezzanine CDO tranche backed by BBB-rated ABS tranches was rated AAA at the senior level using a rating based on a single-factor model with low correlation. Which is the most significant weakness of relying on this approach for the senior CDO tranche rating, as highlighted by the crisis?

The main weakness was underestimating correlation. Underlying BBB ABS tranches shared the same systematic housing factor, so they defaulted together far more than the low-correlation model assumed, causing senior CDO tranches to be rated too highly relative to their true risk.

  1. ARatings measure only liquidity risk, not default risk
  2. BRatings were applied using a market-price-based methodology, which is too volatile
  3. CUnderlying ABS tranche ratings were highly correlated through common systematic factors, so the model understated the probability of joint downgrades and defaultsCorrect
  4. DSenior tranches always have a higher probability of default than the pool

Explanation

Mezzanine ABS tranches in the collateral all depended on the same housing market factor, so their defaults were far more correlated than the model assumed. Underestimated correlation and model risk meant senior CDO tranches were rated too high. The other options misstate what ratings measure or how they are produced.

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