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P2.T6.609. Credit risk securitization and the financial crisis (Crouhy)

David Harper CFA FRM

David Harper CFA FRM
Staff member
Learning objectives: Explain the credit risk securitization process and describe the structure of typical collateralized loan obligations (CLOs) or collateralized debt obligations (CDOs). Describe synthetic CDOs and single-tranche CDOs. Assess the rating of CDOs by rating agencies prior to the 2007 financial crisis.


609.1. Consider the following four elements or aspects of a classic securitization:

I. The "slicing" of securities--i.e., notes that are liabilities issued to investors--into different seniorities and risk profiles
II. The prioritization scheme that determines the distribution of cash flows to the different tranche holders
III. The bankruptcy-remote legal entity who purchases credit-sensitive assets and issues securities to investors
IV. A regulatory reform introduced after the crisis that imposes a requirement on originators or sponsors

Which of the following sequences correctly identifies the above elements or aspects of a securitization?

a. I. Waterfall; II. Risk Retention; III. Special purpose vehicle; IV. Tranches
b. I. Waterfall; II. Special purpose vehicle; III. Risk Retention; IV. Tranches
c. I. Tranches; II. Waterfall; III. Special purpose vehicle; IV. Risk Retention
d. I. Risk Retention; II. Tranches; III. Waterfall; IV. Special purpose vehicle

609.2. Which is a key difference between a collateralized loan obligation (CLO) and a collateralized bond obligation (CBO)?

a. CLOs have higher recovery rates and shorter durations
b. CLOs are a type of CDO but CBOs are a type of CDO-squared
c. In a CLO the entire portfolio is ramped up, but a CBO only issues a single tranche
d. CLO assets are sold to an SPV, but CBO assets remain on the balance sheet of the sponsor

609.3. Crouhy says "Investors in complex [ie., structured] credit products were particularly reliant on rating agencies because they often had little information at their disposal to assess the underlying credit quality of the assets held in their portfolios. " In explaining why the rating of CDOs by rating agencies was misleading, which of the following does Crouhy implicate as a fundamental feature of the structured credit ratings by credit rating agencies (CRA) that greatly contributed to the problem prior to the 2007 financial crisis?

a. Between a CDO tranche and a corporate bond of the same rating, the unexpected loss (UL) should be roughly equivalent but the expected loss (UL) is very different
b. Many investors did not understand that subprime CDOs are made up of individual residential mortgages, instead believing they were corporate obligations
c. Prior to the crisis, Dodd-Frank explicitly called for labeling CDO tranches as "investment grade" despite their underlying fundamental credit quality
d. Corporate bond ratings are largely firm-specific and dependent on the judgment of an analyst, but rating CDOs tranches relies heavily on quantitative models due to correlated assets