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P2.T6.606. Flaws in securitization of subprime mortgages prior to the global financial crisis-Crouhy

Nicole Seaman

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Learning objectives: Discuss the flaws in the securitization of subprime mortgages prior to the financial crisis of 2007. Identify and explain the different techniques used to mitigate credit risk, and describe how some of these techniques are changing the bank credit function. Describe the originate-to-distribute model of credit risk transfer and discuss the two ways of managing a bank credit portfolio.


606.1. In explaining what went wrong with the subprime securitization market, Crouhy goes back to the prior shift from a traditional buy-and-hold business model to an originate-to-distribute (OTD) model:
  • "Securitization involves the repackaging of loans and other assets into securities that can then be sold to investors. Potentially, this removes considerable liquidity, interest rate, and credit risk from the originating bank’s balance sheet compared to a traditional buy-and-hold banking business model. Over a number of years, certain banking markets shifted quite significantly to this new originate-to-distribute (OTD) business model, and the move gathered pace in the years after the millennium."
For many years, the OTD model offered many benefits to originators (eg, greater capital efficiency, enhanced funding availability), investors (who benefited from greater capital efficiency and enhanced funding availability) and borrowers (who benefited from the expansion in credit availability). However, according to Crouhy, the benefits of the OTC model were progressively weakened in the years preceding the crisis and risks began to accumulate. Each of the following is TRUE in describing a key weakness of this OTD model as key contributor to the financial crisis EXCEPT which is not true?

a. Misaligned incentives: The OTD model of securitization reduced the incentives for the originator of the loan to monitor the creditworthiness of the borrower
b. Concentrated risk: Risks that should have been broadly dispersed under a classic OTD model were actually concentrated in entities set up to get around regulatory capital requirements
c. Rating agencies: Despite their central role in the OTD model, CRAs did not adequately review the data underlying securitized transactions and also underestimated the risks of subprime CDO structuring
d. Credit transfer instruments: The disruption caused by an inability to arbitrate triggers and settle credit events in the credit default swap (CDS) market proved that the principle of credit risk transfer is inherently flawed

606.2. Under the originate-to-distribute (OTD) model, what is the key to assessing bank performance?

a. Grid pricing
b. Economic capital
c. Expected losses (EL)
d. Core loans managed by the business unit

606.3. Crouhy explains "By contrast [ie, to the traditional buy-and-hold banking business model], under the originate-to-distribute business model, loans are divided into core loans that the bank holds over the long term (often for relationship reasons) and noncore loans that the bank would like to sell or hedge. Core loans are managed by the business unit, while noncore loans are transfer-priced to the credit portfolio management group. For noncore loans, the credit portfolio management unit is the vital link between the bank’s origination activities (making loans) and the increasingly liquid global markets in credit risk." Each of the following is a goal or mandate of the Credit Portfolio Group EXCEPT which is NOT a goal or mandate of the Credit Portfolio Group?

a. Decrease the velocity of capital
b. Reduce concentration and event risk
c. Increase return on economic capital
d. Manage counterparty risk of derivatives exposure

Answers here: