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Compare how rating agencies, mortgage brokers and lenders, financial intermediaries and banks each figured in the crisis.

FRM® Part I · Foundations of Risk Management · Anatomy of the Great Financial Crisis of 2007-2009 · FRM1.FR.10.d

The idea

Each group had a distinct incentive problem. Mortgage brokers and lenders were paid per loan originated and could sell loans on, so they had little reason to check borrowers. Rating agencies were paid by the issuers whose securities they rated. They used models with low default correlation and short house price histories, and they faced rating shopping by arrangers. Financial intermediaries such as investment banks structured and sold the securities, earning fees on volume. They often kept super-senior tranches or warehoused unsold risk. Banks originated and held loans, sponsored conduits and structured investment vehicles, and gave them liquidity backstops. The risk they thought they had sold returned to their balance sheets when funding markets stopped. For the exam, match each party to its incentive and to the way the risk came back.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which participant faced a conflict of interest in the crisis because the issuers of the securities it assessed were the parties who paid its fees?

  1. Mortgage brokersWhy not: Brokers were paid per loan by lenders and borrowers; they did not assess securities for issuers.
  2. Rating agencies - correct
  3. Money market fundsWhy not: Money funds were investors in short-term paper; they did not receive fees from issuers for opinions.
  4. Central banksWhy not: Central banks were lenders of last resort and received no fees from issuers for rating securities.

Under the issuer-pays model the agencies were paid by the arrangers and issuers of structured products, and received large fees from structured finance deals. This created a pressure to give favourable ratings and to accommodate rating shopping.

A harder one

A bank sponsors an asset-backed commercial paper conduit that holds AAA-rated mortgage securities and funds them by issuing commercial paper. The bank gave the conduit a full liquidity line. When the paper can no longer be rolled over, what happens?

  1. The sponsor may have to fund the conduit, bringing the funding risk and economic exposure back to the bank - correct
  2. Nothing, because the conduit is a separate legal entity and the sponsor has no obligationWhy not: The legal separation did not remove the contractual liquidity line, nor the reputational pressure to support the vehicle.
  3. Only holders of the conduit's equity notes are affected, since commercial paper is senior and always repaidWhy not: Commercial paper investors are only protected if the sponsor honours the line; the line is what returns the risk to the bank.
  4. The central bank automatically repays the commercial paper investors in fullWhy not: No central bank guaranteed conduit paper; support came later through special facilities, not automatically.

The liquidity backstop meant the sponsoring bank was exposed to the funding risk of vehicles it had not consolidated. When markets froze in August 2007 banks had to fund or take back conduit assets, the opposite of the risk transfer they had assumed.

The hardest tier

Which statement correctly matches each participant with its role or incentive in the crisis?

  1. Brokers: paid on volume. Rating agencies: paid by issuers. Investment banks: structured and sold tranches, often keeping super-senior. Banks: sponsored conduits with liquidity lines - correct
  2. Brokers were paid by the issuers of CDOs; rating agencies were paid on loan volume; investment banks only held equity tranches; banks stayed out of securitisationWhy not: Mixes up who paid whom, and wrongly says banks stayed out of securitisation when they sponsored conduits.
  3. Brokers retained the first-loss tranche; rating agencies were paid by investors; investment banks held no securitisation risk; banks sold all loans without recourseWhy not: Brokers did not retain tranches, agencies were paid by issuers, and many investment banks kept super-senior risk.
  4. Brokers earned fees only when loans performed; rating agencies were paid by regulators; investment banks insured the equity tranche; banks acted as lenders of last resortWhy not: Brokers earned fees at origination, regulators did not pay agencies, and banks were not lenders of last resort; that is the central bank.

Brokers and lenders were driven by volume; agencies were paid by issuers; intermediaries earned fees from structuring and often retained super-senior exposure; banks kept liquidity and credit risk through conduits. Each party's incentive explains why risk was ignored or returned to the system.

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