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

After the global financial crisis, regulators criticised reliance on external ratings for structured products. Which weakness of ratings for senior securitisation tranches was most emphasised?

Regulators stressed that ratings for senior structured tranches depend heavily on correlation and model assumptions. Because these tranches are exposed to systemic tail events, a modest change in assumptions or a market-wide shock can cause severe, simultaneous downgrades, so ratings were less reliable than for similarly rated corporate bonds.

  1. ARatings were based on a single default probability and ignored recoveries
  2. BRatings of senior tranches were highly sensitive to the correlation and model assumptions, so they could fall sharply in systemic stressCorrect
  3. CRatings were only assigned to equity tranches and not to senior tranches
  4. DRatings always measured liquidity risk rather than credit risk

Explanation

Senior tranches are exposed to systemic, tail outcomes, so their losses depend on correlation and model assumptions. In the crisis, highly rated tranches were downgraded by many notches at once. The other options misstate how ratings are produced.

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