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FRM Part I · FRM Exam Part I · Banks

Under the originate-to-distribute (OTD) model, a bank makes loans and then sells them to investors, typically through securitization. Which of the following is the main reason this model is widely cited as having weakened lending standards before the 2007-2009 crisis?

The originate-to-distribute model weakened lending standards because the originating bank passed most credit risk to investors. With little exposure left, it had less incentive to screen and monitor borrowers carefully, so loan quality deteriorated.

  1. AThe originating bank bore the full credit losses on loans it sold, so it lent too cautiously
  2. BThe originator transferred much of the credit risk to others, which reduced its incentive to screen and monitor borrowersCorrect
  3. CSecuritization raised the originator's capital requirement on every loan sold
  4. DLoans sold to investors could no longer be priced using market interest rates

Explanation

When loans are sold on, the originator keeps little of the default risk, so its incentive to perform careful credit analysis and monitoring falls. Option A reverses the logic, because under OTD the originator does not bear the full losses.

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