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FRM Part I · FRM Exam Part I · Banks

Critics of the originate-to-distribute model argued it contributed to the 2007-2009 crisis. Which of the following is the most direct explanation of how the model weakened lending standards?

Originators that sold loans transferred most default risk to investors, so they had less incentive to screen and monitor borrowers carefully. This misaligned incentive problem lowered underwriting standards, and it motivated later reforms such as requiring originators to retain a portion of the securitized risk.

  1. AOriginators that sold loans bore little of the default risk, reducing their incentive to screen borrowersCorrect
  2. BOriginators held more equity capital against each loan, forcing them to lend more
  3. CRating agencies refused to rate securitized tranches, limiting investor demand
  4. DInvestors in senior tranches were required to monitor each underlying borrower

Explanation

Because loans were quickly sold, originators had weaker incentives to screen and monitor borrowers, a moral hazard or misaligned incentive problem. This is why reforms such as risk retention requirements were proposed. The other options contradict how the market operated.

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