Financial Risk Manager Part 1
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Which of the following statements best explains how banks created collateralized debt obligations in the build-up to the 2007-2008 financial meltdown?
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TTanishq
A
Forming a diversified portfolio of cash-flow generating assets, pooling them together, and then repackaging the asset pool into discrete tranches that could be sold to investors.
B
Pooling together cash-generating assets, and then repackaging the asset pool into discrete slices that could be sold to investors.
C
Forming a diversified portfolio of mortgage products, pooling them together, and then repackaging the asset pool into discrete tranches that could be sold to investors.
D
Pooling together a well-diversified portfolio of mortgages, and then slicing the pool into three tranches that could be sold to investors.
Explanation:
Explanation
Option A is correct because it accurately describes the process of creating collateralized debt obligations (CDOs):
- Diversified portfolio of cash-flow generating assets: CDOs were created from various types of debt instruments including mortgages, corporate bonds, and other asset-backed securities
- Pooling them together: Multiple assets were aggregated into a single portfolio
- Repackaging into discrete tranches: The pooled assets were structured into different risk levels (senior, mezzanine, equity tranches) with varying risk-return profiles
- Sold to investors: Each tranche was marketed to different types of investors based on their risk appetite
Why other options are incorrect:
- Option B: Too vague about the types of assets and doesn't emphasize diversification
- Option C: Too narrow by focusing only on mortgage products, when CDOs included various types of debt
- Option D: Incorrectly specifies "three tranches" - CDOs typically had multiple tranches, not necessarily exactly three
During the 2007-2008 financial crisis, banks created CDOs by bundling various types of debt, including subprime mortgages, into structured products that were then sold to investors seeking higher yields. This process amplified systemic risk when the underlying mortgages began to default.
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