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A portfolio of subprime mortgages has the following allocation of the principal to tranches: senior 80%, mezzanine 10%, and equity 10%
A portfolio of subprime mortgages has the following allocation of the principal to tranches:
senior 80%, mezzanine 10%, and equity 10%. (The portfolios of subprime mortgages have the
same default rates.) An ABS CDO is then created from the mezzanine tranches with the same
allocation of principal. See the following table which list debt ratings for the different tranches
and for the tranches of the ABS CDO.
Tranche Debt rating
Senior AAA
Mezzanine BBB
Equity Unrated
Senior of ABS CDO ???
Mezzanine of ABS CDO BB
Equity of ABS CDO Unrated
What would be the best estimated rating for the Senior Tranche of ABS CDO?
A) AAA
B) AA or A
C) BBB or BB
D) B or CCC
E) Unrated
Expert Solution
(B) AA or A because Equity of ABS CDO is unrated; meaning thereby losses are firstly absorbed by Equity of ABS CDO. After that mezzanine tranche comes in and Mezzanine rating is BB. Lastly comes Senior Tranche of ABS CDO. Therefore, it is more secure than Mezzanine. Therefore, Rating of Senior Tranche of ABS CDO is between BB and AAA. So, the best estimated rating is AA or A.
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