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FRM Part I · FRM Exam Part I · Credit Risk Transfer Mechanisms

An investor holds a mezzanine tranche of a CDO whose collateral pool contains 100 equally sized loans, each with a 5% default probability. The tranche absorbs losses only between 5% and 15% of the pool. After the crisis, analysts found that actual default correlation was much higher than assumed in the rating model. Which outcome is most consistent with that finding?

Higher-than-assumed default correlation raised the probability of severe, simultaneous pool losses without changing expected pool loss. That made it more likely the mezzanine tranche was wiped out than the model implied, which is why correlation underestimation caused large unexpected tranche losses.

  1. AMezzanine tranche losses were less likely than modeled, since losses are spread across more loans
  2. BBoth the equity and the senior tranche became safer than modeled
  3. CProbability of severe pool losses increased, raising the likelihood that the mezzanine tranche was wiped out relative to the modelCorrect
  4. DExpected pool loss changed materially, while the tail risk of the pool stayed the same

Explanation

Higher correlation does not change expected pool loss (each loan is still 5%), but it fattens both tails: more chance of very few and of very many defaults. Mezzanine and senior tranches, which depend on the pool loss exceeding attachment points, become riskier as the probability of large simultaneous defaults rises. Option D is wrong because expected loss is unchanged while tail risk rises.

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