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Describe how collateralized debt obligations (CDOs) and subprime mortgages helped bring the crisis about.

FRM® Part I · Foundations of Risk Management · Anatomy of the Great Financial Crisis of 2007-2009 · FRM1.FR.10.c

The idea

Subprime mortgages were loans to borrowers with weak credit records, often with high loan-to-value ratios, little documentation and low teaser rates that reset higher after two years. Repayment therefore relied on refinancing as house prices rose. These loans were pooled into mortgage-backed securities and tranched. A CDO repeats the process, and the pool's losses are absorbed first by the equity tranche, then mezzanine, then senior tranches. Each tranche is hit in proportion to how far the pool loss passes its attachment point. Tranche loss = (pool loss − attachment point) ÷ tranche width, capped between 0% and 100%. Many mezzanine tranches were re-packaged into ABS CDOs and rated mostly AAA, even though all depended on the same housing market and defaults were highly correlated. Small pool losses therefore wiped out mezzanine and then supposedly safe senior tranches. The exam favours this correlation and amplification point.

Formulas

Loss on a securitisation tranche

tranche loss rate = min[max(L − A, 0) ÷ (D − A), 1]

L
the loss on the underlying pool, as a share of the pool
A
the tranche's attachment point
D
the tranche's detachment point; D − A is its width

For an ABS CDO apply it twice: the mezzanine tranches' loss rate becomes the CDO pool's loss, which then hits the CDO tranches. Correlated pool losses are amplified at each step.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which description best fits a subprime mortgage borrower?

  1. A borrower with a weak credit record and a higher default risk than prime - correct
  2. A borrower with a large down payment and a strong credit historyWhy not: This describes a prime borrower; subprime borrowers have weak credit and often little equity.
  3. A borrower whose loan carries a government guarantee against defaultWhy not: A government guarantee is a feature of agency or insured loans, not a defining feature of subprime lending.
  4. A borrower with a long-dated fixed-rate loan whose rate never resetsWhy not: Subprime loans commonly had adjustable teaser rates that reset higher; a fixed rate is not what defines subprime.

Subprime loans went to borrowers with poor credit histories or limited documentation, often at high loan-to-value ratios and with teaser rates, so their performance depended heavily on house prices.

A harder one

A subprime mortgage pool is tranched. The mezzanine tranche attaches at 5 percent and detaches at 15 percent of the pool. If pool losses are 9 percent, the loss on the mezzanine tranche as a percentage of its principal is:

  1. 4.0%Why not: Takes the loss above the attachment point (9 - 5) without dividing by the tranche width of 10.
  2. 40% - correct
  3. 60.0%Why not: Computes the unused part of the tranche, (15 - 9) / 10, instead of the loss.
  4. 90%Why not: Divides the pool loss of 9 by the width of 10 and ignores the 5 percent of subordination below the tranche.

Loss on the tranche = (9 - 5) / (15 - 5) = 4/10 = 40%. A modest 9 percent pool loss wipes out 40 percent of a mezzanine tranche, which shows how thin tranches magnify pool losses.

The hardest tier

Mezzanine tranches (attachment 5 percent, detachment 15 percent) of identical subprime pools are used as the collateral of an ABS CDO. The CDO's senior tranche attaches at 25 percent of its collateral and detaches at 100 percent. Each subprime pool loses 12 percent. The loss on the CDO senior tranche as a percentage of its principal is closest to:

  1. 70%Why not: Stops at the first step: this is the loss on each underlying mezzanine tranche, not on the CDO senior tranche.
  2. 45%Why not: Subtracts the 25 percent attachment from the 70 percent collateral loss and does not divide by the tranche width of 75.
  3. 60% - correct
  4. 0%Why not: Compares the 12 percent pool loss directly with the 25 percent attachment point, ignoring the amplification in the mezzanine layer.

Each mezzanine tranche loses (12 - 5)/10 = 70%, so the CDO collateral loses 70%. The senior tranche loses (70 - 25)/75 = 60%. A 12 percent loss in the underlying pools destroys most of a tranche that was rated AAA, showing the double amplification of re-securitisation.

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