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FRM Part II · FRM Exam Part II · Structured Credit Risk

Which of the following best describes how the originate-to-distribute model contributed to deteriorating underwriting standards before the subprime crisis?

Under originate-to-distribute, lenders sold loans to securitization vehicles and passed credit losses to investors. With little skin in the game and fees tied to volume, they had weaker incentives to screen and monitor borrowers, so underwriting standards deteriorated.

  1. AOriginators retained the equity tranche of every pool, which strengthened their incentive to screen borrowers
  2. BOriginators who sold loans into securitizations bore little of the credit loss, weakening their incentive to screen and monitor borrowersCorrect
  3. CRating agencies directly underwrote the loans, which reduced lenders' due diligence
  4. DRegulators required lenders to hold loans on balance sheet, which encouraged riskier lending

Explanation

When loans were sold to securitization vehicles, originators earned fees on volume while transferring default risk, creating a moral hazard that reduced screening and monitoring. Retaining the equity tranche would have aligned incentives, which is the opposite of what generally occurred.

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