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

Which statement best describes why CDOs built from mezzanine tranches of asset-backed securities (ABS CDOs) suffered such severe losses in 2007-2008?

ABS CDOs repackaged mezzanine tranches that all depended on the same US housing market, so their defaults were highly correlated. Rating models assumed much lower correlation and diversification, so supposedly safe senior tranches suffered heavy losses when house prices fell.

  1. ATheir underlying mezzanine tranches had highly correlated defaults tied to the same US housing market, so diversification was far weaker than ratings assumedCorrect
  2. BTheir underlying assets were government bonds with no credit risk
  3. CTheir underlying mezzanine tranches were uncorrelated, which made defaults random and unpredictable
  4. DTheir ratings were set below the ratings of the underlying mortgage loans

Explanation

Mezzanine ABS tranches drew on similar subprime mortgage pools, so they were exposed to the same housing downturn. Ratings models assumed low default correlation, which proved wrong. Thus the AAA-rated senior slices of ABS CDOs suffered heavy losses.

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