This sample question is easier than a typical exam question. As usual, I added some follow up questions to give a stretch - David

[source Full Sample I. E01.10] A bank is considering ways of significantly reducing or eliminating its credit exposure to defaults on a loan portfolio so that the bank’s shareholders do not absorb the losses arising from such defaults. Ignoring institutional issues (e.g., tax, accounting, capital requirements), three of the following programs have a similar impact on the credit risk of the bank. Which alternative fails to reduce credit risk?

a. Sell the loan portfolio in its entirety to another bank.
b. Borrow to finance an additional risk reserve to supplement existing loan-loss reserves.
c. Securitize the loan portfolio.
d. Buy credit protection on the loan portfolio with credit default swaps.

My adds:

* The sample answer says “All three of the other [incorrect] choices are economically equivalent.” Is this true?
* Compare the total risk(s) transferred by outright loan sale (a) to the use of credit default swaps (d).
* The question refers to the motivation to transfer credit risk. What else can motivate securitization of credit-sensitive assets?
* If the bank succeeds in a “true sale” of the credit-sensitive assets in a securitization, who will the assets be sold to? What are the accounting and legal benefits of this true sale?
* If the bank decides to use the loans to originate a collateralized debt obligation (CDO), what is the essential difference between a cash CDO and synthetic CDO?

Answers:

source: Corrrect: B (Borrow to finance an additional risk reserve to supplement existing loan-loss reserves)
All three of the other choices are economically equivalent. Selling loans to an external party eliminates all credit risk for the institution. Similarly, securitizing the loan portfolio removes the loans from the bank’s books and eliminates the credit risk for the institution. Buying credit protection using credit default swaps will offer protection against credit risk. This alternative implies counterparty risk. Borrowing does not work in the long run because shareholders still at some point have to take the hit for default?related losses. Additionally, the increased borrowing to finance the loan loss reserves will increase the risk for the shareholders. Reference: Culp, Chapter 16

The sample answer says “All three of the other [incorrect] choices are economically equivalent.” Is this true?
No. The sale monetizes assets (raises cash) but buying credit protection does not.
Further, the sale is a complete risk transfer, buying credit protection is “merely” a transfer of credit default risk (and perhaps credit deterioration risk). And CDS introduces *counterparty risk;* i.e., exposure to the CDS seller (think AIG).

Compare the total risk(s) transferred by outright loan sale (a) to the use of credit default swaps (d).
As above, sale transfers credit default, deterioration (if M2M), and market (price) risk.
CDS will not hedge market risk.

The question refers to the motivation to transfer credit risk. What else can motivate securitization of credit-sensitive assets?
Aside from customized credit risk transfer, includes but not limited to:
Monetization of assets
Balance sheet motive (shrink balance sheet; e.g., increase certain book based metrics)
Reduce adverse selection cost (increase transparency into firm capital structure)
Reduce regulatory capital requirements (e.g., regulatory capital arbitrage)

If the bank succeeds in a “true sale” of the credit-sensitive assets in a securitization, who will the assets be sold to? What are the accounting and legal benefits of this true sale?
An an SPE or SPV
Accounting benefit: Avoid consolidation
Legal benefit: put the assets in a “bankruptcy remote” vehicle; i.e., if originator files Chapter 7/11, securitized assets protected from creditors.

If the bank decides to use the loans to originate a collateralized debt obligation (CDO), what is the essential difference between a cash CDO and synthetic CDO?
Cash CDO: originator sells the loans to SPE
Synthetic CDO: assets do not change ownership. Rather, credit risk transfer is synthetic vis purchase of credit default swaps.