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FRM Part I · FRM Exam Part I · Learning From Financial Disasters

Mezzanine tranches of subprime mortgage securitizations were often repackaged into collateralized debt obligations (CDOs). Which feature of these structures made the resulting CDO senior tranches, rated AAA, particularly vulnerable in the crisis?

The CDO senior tranches were vulnerable because the underlying mezzanine tranches were highly correlated, all depending on US house prices. Ratings assumed substantial diversification, so when housing fell, losses arrived together and penetrated tranches that had been rated AAA.

  1. AThe underlying mezzanine tranches were highly correlated because they were exposed to the same US housing market, so a housing downturn hit them simultaneouslyCorrect
  2. BThe underlying assets were short-term corporate bonds that matured before the downturn
  3. CThe CDOs were backed by government-guaranteed mortgages that lost the guarantee
  4. DThe CDO tranches were unrated and so priced without reference to credit risk

Explanation

Diversification assumptions relied on low default correlation, but the mezzanine tranches shared exposure to US house prices. When prices fell, losses were highly correlated and reached supposedly safe senior CDO tranches. The other options misdescribe the structures, which were rated and not government-guaranteed.

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