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FRM Part I · FRM Exam Part I · Credit Risk Transfer Mechanisms

A bank originates mortgage loans and sells them to a special purpose vehicle that issues securities, relying on the originate-to-distribute model. Which feature of this model most directly weakened the originating bank's incentive to screen borrowers carefully before the 2007-2009 crisis?

The originate-to-distribute model let banks pass most credit risk to investors, so they earned fees on volume while bearing little loss from bad loans. This reduced their incentive to screen and monitor borrowers carefully, which is a moral hazard problem.

  1. AThe bank retained the full first-loss exposure on each loan it originated
  2. BThe bank transferred most of the credit risk to investors, so its own losses from poor underwriting were smallCorrect
  3. CThe bank was required to hold regulatory capital equal to the full loan amount
  4. DThe bank's compensation depended on long-run loan performance

Explanation

When originators sell loans and pass credit risk to investors, they earn fees on volume while bearing little default loss, which weakens screening and monitoring incentives. Retaining first loss or holding full capital would strengthen incentives, as would compensation linked to long-run performance.

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