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FRM Part I · FRM Exam Part I · Learning From Financial Disasters

In the years before the 2007-2009 crisis, many US banks originated mortgages and then sold them into securitization pools rather than holding them. Which consequence of this 'originate-to-distribute' model contributed most directly to the deterioration of underwriting standards?

The originate-to-distribute model let lenders pass credit risk to investors, so they earned fees on volume without bearing default losses. This weakened their incentive to screen borrowers carefully and contributed to the decline in underwriting standards before the crisis.

  1. AOriginators retained all default risk, so they tightened credit standards
  2. BOriginators transferred much of the credit risk to investors, weakening their incentive to screen borrowers carefullyCorrect
  3. CSecuritization reduced the supply of mortgage credit, raising lending standards
  4. DRegulators required originators to hold first-loss tranches, increasing monitoring

Explanation

When loans are sold on, the originator earns fees on volume but bears little of the later default loss. This moral hazard weakened screening. Retaining the risk would have encouraged tighter standards, so that option is the opposite of what happened.

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