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

Which lesson about structured credit products is most strongly supported by experience in the 2007-2009 crisis?

The crisis showed that reliance on ratings and models with low default correlation assumptions understated tranche risk. When housing fell broadly, defaults became highly correlated across pools, so even highly rated senior and re-securitized tranches suffered large losses.

  1. ASenior tranches of securitizations are immune to losses because of their high ratings
  2. BDependence on ratings and models with low correlation assumptions can understate the risk of tranches during systemic stressCorrect
  3. CDiversification across many mortgage pools eliminates systematic risk
  4. DRe-securitizing mezzanine tranches reduces correlation among the underlying assets

Explanation

Ratings and models assumed limited default correlation, but housing declines raised correlation across pools, so highly rated tranches and re-securitizations suffered large losses. Diversification cannot remove systematic risk, and re-securitization concentrated rather than reduced risk.

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