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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 senior tranches of subprime mortgage-backed CDOs received AAA ratings. Which feature of the rating process most directly contributed to the later wave of severe downgrades of these tranches?

The key flaw was assuming low default correlation across regions, calibrated on a short, benign housing history. When house prices fell nationwide, defaults clustered, so supposedly safe AAA senior tranches were hit and then sharply downgraded.

  1. ARating models assumed that mortgage defaults across regions were only weakly correlated, based on limited historical data from a period of rising house pricesCorrect
  2. BRating agencies were legally required to rate all tranches at the same level as the underlying collateral pool
  3. CRating agencies relied mainly on market prices of credit default swaps rather than on default models
  4. DRating agencies assigned ratings based on liquidity of the securities rather than credit quality

Explanation

Models used short histories from a benign housing period and assumed low default correlation across regions. When house prices fell nationally, defaults became highly correlated and senior tranches suffered losses. The other options describe practices that did not exist or were not the main driver.

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