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FRM Part I · FRM Exam Part I · Anatomy of the Great Financial Crisis of 2007-2009

Before the 2007-2009 crisis, many mezzanine tranches of subprime residential mortgage-backed securities were repackaged into collateralized debt obligations (CDOs). Which feature of this repackaging best explains why a large share of the CDO's senior tranches could receive AAA ratings even though the underlying collateral was rated BBB?

The AAA ratings on senior CDO tranches rested on models that assumed low default correlation among the underlying mezzanine securities. Since all were tied to US housing, correlations were actually high, so the diversification benefit was overstated and the senior tranches were far riskier than their ratings implied.

  1. AThe CDO collateral was guaranteed by the government, so credit risk was eliminated
  2. BRatings models assumed low default correlation among the underlying mortgage-backed securities, so diversification appeared to protect the senior tranchesCorrect
  3. CSenior tranches absorbed the first losses, so they were rated on the basis of expected recovery
  4. DCDO investors were required to hold all tranches, which removed credit risk

Explanation

Ratings of CDO senior tranches depended heavily on assumed low correlation among the collateral assets. Because the BBB mezzanine tranches were all exposed to the same US housing market, correlation was actually high, so diversification was overstated. Senior tranches absorb losses last, not first, which rules out the recovery-based option.

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