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

Under the originate-to-distribute model, a bank originates mortgages and sells nearly all of them to securitization vehicles, retaining no exposure. Which lesson from the 2007-2009 crisis best describes the main incentive problem?

Originators that sell off all loans have weaker incentives to screen and monitor borrowers, because poor underwriting costs them little. This moral hazard in originate-to-distribute lending led to deteriorating loan quality before the 2007-2009 crisis, which is why risk retention is advocated.

  1. AOriginators with no retained exposure have weaker incentives to screen borrowers carefullyCorrect
  2. BSecuritization always increases the capital held by originators
  3. CInvestors in senior tranches bear the first losses on the pool
  4. DBorrowers have less information than lenders about their own ability to repay

Explanation

When loans are passed on, the originator's losses from poor underwriting are small, so screening and monitoring incentives decline. This is a moral hazard problem. Senior tranches bear losses last, not first, and the borrower-information statement describes a different issue.

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