A simple collateralised debt obligation (CDO) is securitised from a pool of mortgage loans and corporate loans with face value 5 million and overall rate of return of 5.5%. The sizes of the senior tranche, mezzanine tranche and equity tranche are given by 55%, 30% and 15% respectively. The promised interest to the senior tranche and the mezzanine tranche are 4.5% and 6% respectively.

A risk analyst at WBS Financial Services estimated that the default rate of the loans would reach 26% by the end of June 2021.

a)Given the information above, calculate the total return and expected loss in principal for each tranche.

b)Critically discuss the role of credit rating agencies in the collapse of the CDO market during the Great Recession.

Answer rating: 100% (QA)

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