Full Answer Section

Factors impacting risk:

• Underlying asset quality:Creditworthiness of individual borrowers in the pool significantly affects default rates and potential losses.
• Pool size and diversification:Larger and more diversified pools tend to spread risk and reduce volatility.
• Tranche size and thickness:Thicker tranches offer greater buffer against defaults compared to smaller ones.

Overall, BBB-tranches are less risky than junior tranches but present higher risk than senior tranches.

4. Risk of Super-Senior Tranches (Second Layer):

Super-senior tranches are typically rated AAA, making them seemingly very safe. However, their risk depends on several factors:

• Structure of the underlying securitization:The quality of lower-rated tranches below the super-senior tranche heavily influences its vulnerability.
• Correlation between underlying assets:High correlation, as seen in subprime mortgages, means defaults can quickly cascade and impact even senior tranches.
• Modeling and rating agency assumptions:Overly optimistic assumptions about default rates could underestimate the true risk.

Super-senior tranches may appear safer than AAA corporate bonds but face unique risks. While generally safer, they are not immune to significant losses if underlying assumptions are flawed or unexpected events occur.

5. Potential Losses for AIG and Collateral Calls:

Yes, AIG faced significant potential losses on its super-senior CDS positions. Even with high ratings, the underlying securitization structure and assumptions in the Bistro deal exposed them to cascading defaults in the subprime market. This materialized during the financial crisis, leading to massive losses and government intervention.

Collateral calls in this context were intended to mitigate AIG’s potential default risk and protect counterparties. By requiring additional capital, they aimed to ensure AIG maintained sufficient resources to meet its CDS obligations.

Whether the calls were justified depends on individual perspectives. While some felt they protected the financial system, others argued they unfairly burdened AIG and contributed to its bailout.

Key takeaway: Despite high ratings, seemingly safe tranches and CDS positions can harbor significant risk, especially in complex and interconnected financial systems. Careful due diligence and risk management are crucial to mitigate potential losses.

Disclaimer: This information is for educational purposes only and does not constitute financial advice. Please consult with a qualified professional for investment decisions.