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

Under the originate-to-distribute model, a bank originates loans and sells them to securitization vehicles. Which of the following is the most significant lesson from the 2007-2009 crisis regarding incentives in this model?

Originators that retain little of the credit loss after selling loans may weaken screening and monitoring, creating moral hazard. This incentive problem was a key lesson of the crisis and motivated risk-retention requirements so originators keep some skin in the game.

  1. ASelling loans to third parties eliminates all incentives for the originator to monitor borrowers
  2. BOriginators who bear little of the credit loss after sale may weaken screening and monitoring standardsCorrect
  3. CSecuritization always raises the originator's capital charge, discouraging lending
  4. DCredit risk transferred to investors cannot return to the banking system

Explanation

When the originator passes on the credit risk, it has weaker incentive to screen borrowers carefully, creating moral hazard and adverse selection for investors. Retention of a share of the risk (skin in the game) is a response. Option A overstates the effect (it is not total), and option D is contradicted by the crisis when banks suffered losses through conduits and retained tranches.

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