FINC6023 · Financial Risk Management
ABSs, CDOs & the 2007-08 Financial Crisis
ABSs, CDOs & the 2007–08 Financial Crisis is the narrative capstone. Securitisation pools loans and slices the cash flows into tranches — Senior (AAA), Mezzanine (BBB) and Equity (unrated) — paid in a waterfall that protects the senior tranche. Repackaging mezzanine tranches into an ABS CDO re-rated much of that risk as AAA. The crisis chain ran from loose subprime lending through a house-price bubble to mass default, and the central modelling error was understating how much tranche values depend on default correlation, which spikes in a downturn.
What this chapter covers
- 01Securitisation and the ABS structure: Senior/Mezzanine/Equity tranches
- 02The waterfall: senior paid first, equity absorbs first losses
- 03Originate-and-distribute and the moral-hazard problem
- 04ABS CDO, CDO² and synthetic CDO (built from CDSs)
- 05The crisis chain: subprime → bubble → 2006 slump → default → flight to quality
- 06Key modelling mistakes: AAA risk understated, correlation rises in stress
- 07Fixes: transparency, simplification, originators retain a slice
Walk the waterfall and explain the correlation trap
- 1 markSize the tranches in dollars: Equity = 5% × 100m = $5m; Mezzanine = 20% × 100m = $20m; Senior = 75% × 100m = $75m.
- 1 markApply the waterfall: the first $5m of loss is fully absorbed by the Equity tranche (now wiped out).
- 2 marksThe 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.
- 1 markThe Senior tranche takes $0 loss because losses ($12m) did not exhaust the $25m of subordination below it.
- 1 markExplain: 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.
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.
Exam move
This chapter is mostly conceptual, so learn the tranche structure, the waterfall order and the crisis chain as a story you can retell. The single most examinable point is that tranche (especially senior) values depend on default correlation, which rose in the downturn — be able to state that in one sentence.
