FINC6023 Chap.12 ABSs, CDOs & the 2007-08 Financial Crisis
ABSs, CDOs & the 2007-08 Financial Crisis
ABSs, CDOs and the Financial Crisis is the narrative capstone of the unit. Securitisation transfers a pool of loans to a special-purpose vehicle and issues claims on the pool's cash flows. Tranching creates a waterfall. Interest and principal are paid to senior claims before junior claims, while losses are absorbed in the opposite order.
Equity provides first-loss protection, mezzanine absorbs the next layer, and senior tranches are protected until subordination is exhausted.
Re-securitisation can place mezzanine tranches from several asset-backed securities into a new collateralised debt obligation. A synthetic structure gains credit exposure through credit default swaps rather than by holding the underlying loans.
These structures do not remove the underlying credit risk. They redistribute cash flows and loss priority, and their values depend heavily on default rates, recovery, prepayment, and the dependence among borrowers.
Correlation changes who bears loss. With low default correlation, losses are more dispersed and junior protection is less likely to be exhausted at once.
With high correlation, many loans can default together, pushing losses rapidly into senior tranches. A model that fixes correlation at a benign level can therefore understate the probability of severe tranche loss precisely when economic conditions deteriorate.
The crisis chain joins incentives and modelling.
Originate-and-distribute lending weakened screening incentives, rising house prices supported refinancing, leverage magnified exposure, and complex structures obscured common risk. When housing conditions reversed, defaults became more dependent, ratings and prices adjusted, funding weakened, and forced sales reinforced the decline.
Exam preparation should focus on the waterfall, the effect of correlation, the moral-hazard channel, and why repackaging did not create diversification when the underlying exposures shared the same systematic driver.
What this chapter covers
- 01
Securitisation and the ABS structure: Senior/Mezzanine/Equity tranches
- 02
The waterfall: senior paid first, equity absorbs first losses
- 03
Originate-and-distribute and the moral-hazard problem
- 04
ABS CDO, CDO² and synthetic CDO (built from CDSs)
- 05
The crisis chain: subprime → bubble → 2006 slump → default → flight to quality
- 06
Key modelling mistakes: AAA risk understated, correlation rises in stress
- 07
Fixes: transparency, simplification, originators retain a slice
Worked example · free
Walk the waterfall and explain the correlation trap
- 1Size the tranches in dollars: Equity = 5% × 100m = $5m; Mezzanine = 20% × 100m = $20m; Senior = 75% × 100m = $75m.
- 1Apply the waterfall: the first $5m of loss is fully absorbed by the Equity tranche (now wiped out).
- 2The remaining 12 − 5 = $7m of loss hits the Mezzanine tranche, which can absorb up to $20m, so Mezzanine takes a $7m loss and survives with $13m left.
- 1The Senior tranche takes $0 loss because losses ($12m) did not exhaust the $25m of subordination below it.
- 1Explain: the Senior tranche only loses once losses breach the subordination, which is far more likely when defaults are highly CORRELATED — and correlation rose sharply in the downturn, so the AAA tranche was riskier than its rating assumed.
Key terms
- Securitisation / ABS
- Pooling loans (mortgages, receivables) into a special-purpose vehicle and issuing tranches backed by the pool's cash flows. The tranches are Senior (AAA), Mezzanine (BBB) and Equity (unrated).
- Waterfall
- The rule allocating cash flows and losses across tranches: principal and interest are paid to senior tranches first, while losses are absorbed by the equity tranche first and the senior tranche last.
- ABS CDO / CDO²
- A re-securitisation that repackages the mezzanine tranches of ABSs into new tranches, much of it re-rated AAA; a CDO² repackages CDO tranches again. A synthetic CDO is built from credit default swaps rather than actual loans.
- Default-correlation lesson
- Tranche values, especially senior ones, depend heavily on the assumed correlation of defaults. Underestimating correlation made AAA tranches look safe; correlation rose in the downturn and the senior tranches proved risky.
- Subordination
- Subordination is the junior capital positioned below a tranche in the waterfall, absorbing losses before that tranche and providing its principal credit protection.
- Synthetic CDO
- A synthetic CDO creates exposure to a reference credit portfolio through credit default swaps rather than by owning the underlying loans or bonds.
ABSs, CDOs & the 2007-08 Financial Crisis FAQ
Why was the AAA rating on senior tranches misleading?
The senior tranche only suffers losses once the subordinated tranches below it are exhausted, which requires many loans to default together. Ratings models assumed defaults were largely independent (low correlation); in the crisis correlation surged, so simultaneous defaults became common and the supposedly safe AAA tranches took losses.
What is the moral-hazard problem in originate-and-distribute?
When an originator sells the loans on rather than holding them, it bears little of the default risk, so its incentive to screen borrowers weakens. This drove lax subprime lending. A standard fix is to require originators to retain a slice of the risk so their incentives align with investors.
How does a synthetic CDO differ from a cash CDO?
A cash CDO holds actual loans or bonds and passes their cash flows through the waterfall. A synthetic CDO holds no underlying loans at all — it gains its credit exposure by selling protection through credit default swaps, so its 'assets' are CDS positions referencing a portfolio of names.
How do losses move through an ABS waterfall?
Allocate pool losses to the equity tranche first, then to mezzanine, and only then to senior claims after junior balances are exhausted. Cash payments move in the opposite priority, with senior claims paid first. A useful check is that allocated losses equal total pool loss and never exceed each tranche balance.
Why does correlation matter more for senior tranches?
Senior claims are protected against scattered small losses by the subordinated tranches beneath them. Higher default correlation increases the chance that many loans fail together, exhausting that protection in one state of the world. The mean number of defaults may be similar while the probability of a severe joint-loss state rises sharply.
Exam move
Draw one waterfall with equity, mezzanine, and senior balances, then send several loss amounts through it. Always allocate losses from the bottom upward and payments from the top downward. Check that allocated losses equal total pool loss and never exceed a tranche's remaining balance. Next compare low- and high-correlation cases without changing marginal default probabilities.
Explain that higher correlation concentrates losses into joint states, increasing the chance that junior protection is exhausted and senior tranches are reached. Build the crisis narrative as a causal chain rather than a list of dates: weakened screening, common housing exposure, leverage, optimistic dependence assumptions, rising defaults, funding stress, and forced deleveraging.
For every link, identify the risk family and the feedback into the next link. Distinguish cash and synthetic CDOs by the source of exposure. In written practice, finish by naming the model assumption or incentive failure that made the outcome worse instead of merely stating that securitisation was complex.
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