The Risk of Tranches Created from Residential Mortgages

by John Hull of the University of Toronto, and
Alan White of the University of Toronto

May 2010

Abstract: This paper examines, ex-ante, 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 totally 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 and the correlation model. The BBB tranches of ABSs cannot be considered equivalent to BBB bonds for the purposes of subsequent securitizations.

Keywords: subprime, mortgages, ABS, ABS CDO, rating.

Published in: Financial Analysts Journal, Vol. 66, No. 5, (September/October 2010), pp. 54-67.

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