Skip to content

FRM Part I · FRM Exam Part I · Banks

Which of the following best explains why the originate-to-distribute model weakened lending standards before the 2007-2009 crisis?

Originators sold loans soon after making them, so they bore little of the later default losses. This weakened their incentive to screen and monitor borrowers, a moral hazard problem. Fees depended on origination volume rather than loan quality, which encouraged looser underwriting.

  1. AOriginators that quickly sold loans had less incentive to screen borrowers carefully because they bore little of the eventual default lossCorrect
  2. BRegulators required originators to hold the equity tranche of every securitization
  3. CInvestors in senior tranches demanded stricter underwriting than banks had applied before
  4. DOriginators were unable to earn fees unless loans were of high quality

Explanation

Because the originator passed credit risk to investors, its own exposure to default was small, so the incentive to monitor and screen fell, creating a moral hazard problem. Retention requirements came after the crisis and would work in the opposite direction. Fee income depended on volume, not quality.

Did you get it right without looking?

One question tells you little. A timed set on Banks shows your real accuracy, how long you take and where you lose marks.

Practise BanksFree diagnostic mock

More Banks questions