Thursday, May 28, 2009

The Risk of Tranches Created from Residential Mortgages

Posted on DefaultRisk.com by John Hull and Alan White:

Abstract: This paper examines the risk in the tranches of ABSs and ABS CDOs that were created from residential mortgages between 2000 and 2007. Using the criteria of the rating agencies, it tests how wide the AAA tranches can be under different assumptions about the correlation model and recovery rates. It concludes that the AAA ratings assigned to the senior tranches of ABSs were not unreasonable. However, the AAA ratings assigned to tranches of Mezz ABS CDOs cannot be justified. The risk of a Mezz ABS CDO tranche depends critically on the correlation between mortgage pools as well as on the correlation model and the thickness of the underlying BBB tranches. The BBB tranches of ABSs cannot be considered equivalent to BBB bonds for the purposes of subsequent securitizations.

Download paper (259K PDF) 25 pages

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