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FRM Part I · FRM Exam Part I · Mortgages and Mortgage-Backed Securities

Which feature of the pre-2007 originate-to-distribute model most directly weakened lenders' incentives to screen subprime borrowers carefully?

The key feature was that originators sold loans into securitizations and so passed most default risk to investors. Because they earned fees on volume and bore little of the credit loss, their incentive to screen subprime borrowers carefully weakened.

  1. ALenders retained the equity tranche of every securitization
  2. BLenders sold loans to securitizers and so transferred most of the default risk to investorsCorrect
  3. CLenders were required to hold the loans to maturity on their balance sheets
  4. DLenders only originated loans with full documentation and low loan-to-value ratios

Explanation

When originators sell loans for securitization, they earn fees on volume while bearing little of the default risk, which reduces screening effort. Retaining risk, holding to maturity or strict underwriting would strengthen incentives, not weaken them.

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