How does securitization create moral hazard, and what risk retention rules try to fix it?

Securitization separates the entity that originates loans from the entity that bears the credit risk. This separation creates classic moral hazard — the originator has less incentive to maintain lending standards if they can offload the risk.

The Moral Hazard Chain:

1. Originate-to-distribute: Banks originate mortgages specifically to securitize them, not to hold them. No 'skin in the game' means less careful underwriting.
2. Information asymmetry: The originator knows more about loan quality than investors. They can cherry-pick bad loans for securitization.
3. Servicer conflicts: The servicer (often the originator) may not maximize recoveries if they don't bear the loss.
4. Rating agency failures: Agencies were paid by issuers and had incentives to assign favorable ratings.

Pre-Crisis Example — Foxworth Mortgage Corp:

• Originated $2B in mortgages annually
• Securitized 95% within 90 days
• Relaxed lending standards progressively: no-doc loans, stated-income, 100% LTV
• Result: 30%+ default rates on 2006-2007 vintages

Post-Crisis Risk Retention Rules:

US (Dodd-Frank Section 941):

• Securitizers must retain at least 5% of the credit risk
• Can be horizontal (first-loss equity), vertical (5% of each tranche), or L-shaped (combination)
• QRM (Qualified Residential Mortgage) exemption for highest-quality mortgages

EU (CRR Article 405):

• Similar 5% retention requirement
• Investor due diligence obligations — investors must verify the originator's retention

Basel III:

• Higher capital charges for securitization exposures
• SEC-IRBA (Internal Ratings-Based Approach for Securitization) with more conservative calibration
• STC (Simple, Transparent, Comparable) criteria for preferential treatment

Do They Work?

FRM Key Points:

• Risk retention aligns interests but doesn't eliminate them — 5% retention still means 95% is transferred
• 'Skin in the game' works best for horizontal retention (first-loss), not vertical (5% of each tranche)
• Regulatory arbitrage: some risk migrates to less-regulated sectors (CLO managers, insurance)
• The exam tests your understanding of HOW retention structures work, not just that they exist

Study securitization regulation in our FRM Part II course.