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FRM Part I · FRM Exam Part I · Mortgages and Mortgage-Backed Securities

Why did the credit ratings of many AAA-rated subprime MBS and CDO tranches fall sharply in 2007-2008?

Defaults were highly correlated because borrowers shared exposure to falling house prices. Ratings had assumed low correlation and rising prices, so when prices dropped nationwide, losses spread beyond junior tranches and hit supposedly safe senior tranches, causing sharp downgrades.

  1. ADefaults across the underlying mortgages were highly correlated because they shared exposure to falling house pricesCorrect
  2. BDefaults on mortgages were independent, so tranche losses were diversified away
  3. CInterest rates fell, causing prepayments to eliminate all senior tranches
  4. DAgencies withdrew guarantees from the senior tranches

Explanation

Ratings relied on assumptions of low default correlation and continued house price growth. When house prices fell nationwide, defaults were highly correlated, so losses reached senior tranches. Independent defaults would have supported the ratings, and senior non-agency tranches carried no agency guarantee.

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