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

An originator securitizes loans and retains the first-loss (equity) piece. What is the main purpose of this retention from the investors' viewpoint?

Retaining the first-loss piece aligns the originator's incentives with loan quality. Because the originator absorbs the initial losses, it has reason to underwrite carefully, which reduces the moral hazard of the originate-to-distribute model.

  1. AIt aligns the originator's incentives with loan quality, reducing moral hazard in underwritingCorrect
  2. BIt eliminates all credit risk in the senior tranches
  3. CIt guarantees a AAA rating for the mezzanine tranche
  4. DIt converts the securitization into an on-balance-sheet funding with no risk transfer

Explanation

Under the originate-to-distribute model, originators had little incentive to screen borrowers. Retaining the first-loss piece gives them skin in the game, so poor underwriting hurts them first. It does not eliminate senior risk or guarantee ratings.

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