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FRM Part I · FRM Exam Part I · External and Internal Credit Ratings

Which statement best describes a limitation of relying on external ratings for structured finance products such as CDO tranches before the 2007-2009 crisis?

The key limitation was that ratings summarized default likelihood under model assumptions but conveyed little about correlation and systemic risk. Highly rated structured tranches depended on assumed low default correlation, so when common shocks hit in the crisis, they suffered losses far beyond what their ratings implied.

  1. ARatings on tranches captured default probability but gave little information about correlation and systemic risk, so highly rated tranches could be very sensitive to common shocksCorrect
  2. BRatings on tranches were unavailable because agencies refused to rate securitizations
  3. CRatings on tranches were based only on the credit of the originating bank's equity
  4. DRatings on tranches fully reflected market liquidity and price volatility

Explanation

Senior tranches received top ratings based on models relying on assumed low default correlation. When correlations rose in the crisis, those tranches suffered large losses, showing that a single rating poorly conveys exposure to systematic risk. Agencies did rate securitizations extensively, so the second option is false.

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