Skip to content

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

Which statement best describes why a CDO built from mezzanine tranches of mortgage securitizations (a mezzanine ABS CDO) suffered much larger losses than diversification arguments implied?

Underlying mezzanine tranches were highly correlated because they relied on the same US housing market and similar loan quality. Ratings assumed diversification, but when house prices fell, defaults clustered and losses spread through the CDO, wiping out tranches that had been rated as very safe.

  1. AThe underlying tranches were highly correlated because they depended on the same US housing market, so defaults clusteredCorrect
  2. BThe underlying tranches were all government guaranteed, so losses were transferred to taxpayers
  3. CMezzanine tranches had no credit risk before 2007
  4. DRatings agencies had assigned the underlying tranches speculative grades that were later raised

Explanation

Ratings of the senior CDO tranches assumed low default correlation among the underlying mezzanine tranches. These all depended on the same housing market and underwriting standards, so when house prices fell the losses were highly correlated and wiped out much of the structure.

Did you get it right without looking?

One question tells you little. A timed set on Learning From Financial Disasters shows your real accuracy, how long you take and where you lose marks.

Practise Learning From Financial DisastersFree diagnostic mock

More Learning From Financial Disasters questions