Suppose that ABSs are created from portfolios of subprime mortgages with the following allocation of the principal to tranches: senior 94.5% (rated AAA), mezzanine 0.1% (rated BBB), and equity 5% (rated C) . The portfolios of subprime mortgages have the same default rates. An ABS CDO is then created from the mezzanine tranches. Which of the following is true?
A) The ABS CDO tranches should have similar ratings ranging from AAA to C
B) The ABS CDO tranches should all be rated BBB
C) The ABS CDO tranches should all be rated C
D) The ABS CDO tranches are almost worthless because the mezzanine tranches are so thin

Question

Quizplus · Accepted Answer

The mezzanine tranches are the riskiest of the subprime mortgage tranches, but still have some creditworthiness. By creating an ABS CDO from these tranches, the risk is spread across a diversified portfolio. However, since the mezzanine tranches are only 0.1% of the total portfolio, the ABS CDO tranches would need to be even more diversified to spread the risk appropriately. Rating agencies would likely rate these tranches as BBB, reflecting the increased risk but still some level of creditworthiness.

Suppose That ABSs Are Created from Portfolios of Subprime Mortgages