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:
- Regulatory capital relief: moving credit exposure off the balance sheet reduces risk-weighted assets and frees capital for other lending.
- 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. The "true sale" requirement is not a formality. If the originator retains too much economic exposure or operational control, courts may consolidate the SPV back onto the originator's balance sheet.
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.
- TRS transfers the full economic return including spread moves; CDS transfers default-event risk only; CLN is a funded form of CDS 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. Need full economic exposure off → TRS or true-sale securitization. Need default-event protection only → CDS. Need to preserve client relationship → CDS, not syndication. Need regulatory capital relief → securitization with true sale.
The full lesson (about 2,838 words, 19 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
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