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FRM Part I · FRM Exam Part I · Anatomy of the Great Financial Crisis of 2007-2009

Which description most accurately characterizes the role of the 'originate-to-distribute' model in the institutional failures of the 2007-2009 crisis?

Originate-to-distribute let lenders sell loans through securitization, which weakened their incentive to underwrite carefully because they did not keep the credit risk. However, banks still retained exposure through held tranches, warehouse pipelines, and off-balance-sheet vehicles, so losses eventually returned to their balance sheets.

  1. ALenders retained nearly all mortgages on balance sheet, so concentrated losses directly depleted their deposit insurance funds
  2. BLenders sold loans into securitizations, which weakened their incentive to screen borrowers carefully, while some risk returned to banks through retained tranches and conduitsCorrect
  3. CLenders originated loans only to prime borrowers, so losses arose entirely from corporate lending
  4. DLenders used the model to increase capital requirements, which reduced their lending capacity before 2007

Explanation

Because originators passed loans to investors through securitization, they bore less of the default risk and had weaker screening incentives. Yet banks still held exposure via retained tranches, warehouse inventory, and off-balance-sheet vehicles, so losses came back to them. The other options contradict this mechanism.

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