medium · FRM Part 1 Foundations of Risk Management

In the context of the 2007-2009 Financial Crisis, what was the primary 'model error' associated with the AAA ratings of senior mortgage-backed security tranches?

1. The models simply assumed that house prices would never decline on a nationwide basis.
2. The models failed to adequately account for how rising interest rates affect prepayment speeds.
3. The models assumed default correlations were low and stable across different geographies.
4. The models applied an inappropriately high loss recovery rate assumption for defaulted subprime loans.

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