Name the chief parties taking part in securitizing assets, and spell out where their interests may clash.
The idea
A securitization involves several parties. The originator makes or buys the loans and sells them to a special purpose vehicle, which issues the notes. The arranger or underwriter structures and sells the deal, and the servicer collects payments and handles delinquencies. The trustee or custodian holds the assets and runs the waterfall tests, rating agencies rate the tranches, and investors buy them. A CDO manager may also select the collateral. Conflicts arise because many parties are paid for completing deals, not for long-run performance. An originator that sells the loans has weaker incentive to screen borrowers, and rating agencies are paid by the issuer. A manager holding equity prefers risk, and servicers are paid on balances. Exam point: match each party with the incentive that departs from the investor's interest, such as adverse selection for the originator.
A practice question
The conflict of interest most commonly cited for credit rating agencies in securitization is that:
- they are paid by the issuer or arranger whose deal they rate. - correct
- they hold the equity tranche of the deals they rate.Why not: Rating agencies do not normally hold the equity tranche; the concern is how they are paid.
- they service the underlying loans.Why not: Servicing is performed by the servicer, not the rating agency.
- they select the collateral for CDOs.Why not: Selecting collateral is the job of the CDO manager or the arranger.
Issuer-paid ratings create a risk that agencies compete for business with favourable ratings, and the arranger can shop between agencies for the largest senior tranche.
A harder one
Under an originate-to-distribute model, an originator sells all the loans it makes into securitizations and retains no exposure. The main incentive problem for investors is that the originator:
- will refuse to sell loans that perform well.Why not: The originator wants to sell loans, and its incentive problem is toward quality, not toward withholding the best loans.
- has little reason to screen borrowers, as it bears none of the losses. - correct
- must hold the senior tranche, which lowers its capital.Why not: The model assumes the originator keeps nothing; holding the senior tranche would be retention, which reduces the problem.
- is paid out of excess spread before the senior investors.Why not: The originator's incentive issue arises from sale proceeds; excess spread is not the cause.
When risk is sold, origination fees depend on volume rather than loan quality. Investors face moral hazard in screening and adverse selection, since the originator knows more about the loans than the buyer does.
The hardest tier
An arranger obtains preliminary ratings from three agencies, asks each what share of the structure could be rated AAA, and hires the agency that allows the largest AAA share. The incentive problem illustrated is best described as:
- adverse selection by the servicer, which hides delinquent loans.Why not: The servicer is not involved; the issue is the choice of the rating agency.
- moral hazard of the trustee, which fails to run the waterfall tests.Why not: The trustee is not involved; the arranger is picking the rater.
- model risk in the Gaussian copula, which understates correlation.Why not: Model risk concerns the correlation input; the case is an incentive problem between arranger and raters.
- ratings shopping, which biases the published ratings upward because the issuer chooses the rater. - correct
Because the issuer pays and can choose among raters, the one with the most lenient model wins the mandate. The result is ratings that overstate the quality of senior tranches, which investors then rely on.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
Start free →More in Structured Credit Risk
- Outline the usual kinds of structured products.
- Outline how tranching works and how credit losses are spread across tranches in a securitization.
- Describe how a securitization's waterfall is organised.
- Work through and evaluate the first iteration or two of interim cashflows for a securitization split into three tiers.
- Spell out how excess spread is dealt with in a securitization structure, and work out the overcollateralization account's value as each year ends.
- Account for the tests a custodian runs on excess spread at each year end to decide what cash flows to the overcollateralization account and to equity noteholders.
- Spell out a simulation-based way of arriving at credit losses for each tranche of a securitization.
- Show why a securitization's credit risk depends on the default probabilities and default correlations of its collateral.
- Account for how tranche default sensitivities are gauged.
- Spell out the factors of risk to which structured products are subject.
- Show what is meant by implied correlation and the way it can be gauged.
- Name the motives behind the use of structured credit products.