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

An originator retains the equity tranche of its own securitisation rather than selling it to investors. Which statement best describes the main risk-management rationale for this retention?

Retaining the equity tranche aligns the originator's incentives with loan quality. Because the originator absorbs the first losses, it has less reason to originate weak loans and pass them to investors, which mitigates the moral hazard inherent in the originate-to-distribute model.

  1. AIt aligns the originator's incentives with loan quality because it bears first losses, mitigating moral hazard in originationCorrect
  2. BIt eliminates all credit risk of the pool for the originator because equity is the safest tranche
  3. CIt increases the senior tranche's credit rating by raising the pool coupon
  4. DIt removes the need for any credit enhancement elsewhere in the structure

Explanation

Retaining the first-loss piece gives the originator skin in the game, reducing the incentive to originate poor loans for sale into the structure. Equity is the riskiest tranche, not the safest. Retention does not change the pool coupon and does not replace other credit enhancement.

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