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

Which statement best describes how a CDO of asset-backed securities (a resecuritization) built from mezzanine MBS tranches contributed to the crisis?

Resecuritizing mezzanine MBS tranches into CDOs created a large share of AAA-rated securities even though the underlying tranches shared the same housing-market risk. Their correlated defaults meant the supposedly safe senior CDO tranches suffered large losses when house prices fell.

  1. AIt diversified away systematic housing risk because the underlying tranches were uncorrelated
  2. BIt converted mezzanine tranches into a large proportion of AAA-rated securities despite being highly exposed to the same housing riskCorrect
  3. CIt eliminated the need for credit rating agencies in structured finance
  4. DIt transferred all losses to the originating banks' equity holders immediately

Explanation

Mezzanine MBS tranches were all driven by the same US housing factor, so their defaults were highly correlated. Yet the CDO structure produced a large senior portion rated AAA, which suffered heavy losses when house prices fell. The diversification claim is wrong because correlation was high in the common factor.

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