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

An originator of auto loans wants to reduce the risk that it sells poor-quality loans into a securitization. Which structural feature most directly addresses this moral hazard by aligning the originator's interests with those of investors?

Requiring the originator to retain the first-loss equity piece best aligns incentives. Because the originator absorbs the initial defaults, it bears the consequences of poor underwriting, which reduces the moral hazard created when loans are originated only to be sold to investors.

  1. ARequiring the originator to retain the first-loss (equity) piece of the securitizationCorrect
  2. BSelling all tranches to third-party investors at par
  3. CUsing a larger number of senior tranches
  4. DPaying the rating agency a fee based on the volume of deals

Explanation

Retaining the first-loss piece means the originator bears the initial defaults, so it has an incentive to screen and underwrite carefully. Selling everything removes its exposure and worsens the originate-to-distribute problem. More senior tranches and volume-based rating fees do not align incentives, and the fee arrangement adds a conflict.

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