A bank originates a $500 million pool of mortgages and wants the credit risk off its balance sheet. Three paths exist: insure each loan individually, sell the loans into an SPV that issues bonds, or buy a credit default swap on the pool. Each transfers risk; each creates a different residual exposure on the originator. The exam tests whether you can match the mechanism to the risk being moved and the new risks being introduced.
Three motivations recur:
- Potential regulatory capital relief: recognized credit-risk transfer can reduce capital needs, subject to applicable rules and charges for retained exposures.
- Concentration management: a bank with 2B without losing the client relationship.
- Funding: securitization converts illiquid loans into cash by selling to investors.
The transfer mechanism matters because each method has different counterparty, basis, and operational risks. Transferring credit risk does not make it disappear. It relocates it, and the originator inherits the residual exposures the chosen mechanism creates.
Common mistakes
- Treating risk transfer as risk elimination. Buying CDS does not eliminate credit risk; it converts it to counterparty risk plus basis risk. Selling loans into an SPV does not eliminate them if the bank retains servicing or first-loss exposure.
- Confusing CDS premium with default probability. CDS spread approximates PD × LGD, NOT just PD. A 250 bps spread on a name with 60% LGD implies PD around 4%, not 2.5%. Trap: a question gives you a CDS spread and asks for the implied PD; the choice that ignores LGD is wrong.
- Treating SPV bankruptcy remoteness as automatic. Legal isolation, accounting consolidation and capital recognition are distinct assessments. Bankruptcy remoteness depends on the legal structure and enforceable asset transfer. Retained risk and control can affect accounting or capital treatment without automatically proving the SPV is part of the originator's bankruptcy estate.
Bottom line
- Traditional credit-risk mitigation (netting, collateral, third-party guarantees, credit insurance) reduces exposure but does not transfer risk to capital markets.
- Credit derivatives (single-name and index CDS, total return swaps, CLNs) transfer credit risk to a counterparty without selling the underlying loan.
- A TRS hedger pays total return and receives the financing leg. CDS settles on specified credit events and also has credit-spread sensitivity before default. CLN is a funded form of credit protection.
- CDS spread approximates PD × LGD on an annualized basis; a 200 bps spread on a 50% LGD name implies a 4% PD.
Exam shortcut
When a question asks which credit-risk transfer mechanism fits a scenario, decide what gets transferred and what is preserved. To exchange a reference asset's full return, consider paying total return in a TRS. For specified credit-event protection, consider CDS, while recognizing its spread sensitivity. A CDS can preserve loan ownership and the borrower relationship.
The full lesson (about 3,766 words, 25 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
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