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FRM Part II · FRM Exam Part II · Structured Credit Risk

A bank originates subprime mortgages under an originate-to-distribute model, selling them into securitizations with minimal retained exposure. Which is the most direct risk-management lesson regarding this model highlighted by the crisis?

The key lesson is that originate-to-distribute weakened underwriting discipline because originators kept little exposure. Misaligned incentives let poor loans be sold on, so retention requirements and better incentive alignment are needed to restore skin in the game.

  1. AOriginators should securitize more loans to reduce capital needs further
  2. BWeak skin in the game created misaligned incentives, reducing underwriting standards, so risk retention and better alignment are neededCorrect
  3. CCredit ratings should be replaced by equity prices as the sole basis for underwriting
  4. DSecuritization should be restricted to loans with fixed interest rates only

Explanation

When originators pass credit risk on to investors, they have less incentive to screen borrowers, a moral hazard problem. Risk retention requirements address this misalignment. The other options do not address the incentive problem.

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