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FRM Part II · FRM Exam Part II · An Introduction to Securitisation

A risk manager reviewing an originator's ABS programme notes that the originator sold the equity tranche to an unrelated hedge fund and retained none of the pool's credit risk, while the pool quality deteriorated over successive vintages. Which action best addresses the underlying structural problem?

Requiring the originator to retain a meaningful economic interest, such as a slice of each tranche or the first-loss piece, best addresses it. Retention realigns incentives so the originator bears losses from poor underwriting, countering the moral hazard inherent in a full originate-to-distribute transfer.

  1. ARequire the originator to retain a meaningful economic interest in the securitised exposuresCorrect
  2. BIncrease the number of tranches so that each is smaller
  3. CReplace the SPV with a direct sale to a single investor
  4. DRaise the coupon on the senior tranche to attract more buyers

Explanation

The deterioration reflects misaligned incentives from full risk transfer. Risk retention requirements restore skin in the game. More tranches, a different buyer or higher coupons do not fix the incentive problem.

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