Research in Progress
Securitization Chain: Moral Hazard Exacerbation or Gains from Specialization?
A central question related to the recent financial crisis is whether the originate-to-distribute model of financial intermediation exacerbated moral hazard among financial intermediaries and resulted to origination of loans with low quality. In this paper we develop a model of a competitive economy in which financial intermediation requires a combination of screening and monitoring activities. We consider two types of intermediation: when the loan’s originator remains responsible for servicing the loan as well (Affiliated loans) and when the originator outsources the servicing to a specialized servicer (Unaffiliated loans). In the competitive equilibrium, the gains from specialization exceed the cost of separating the originator from the servicer only for loans with lower probability of repayment. The inferior performance of unaffiliated loans results from the optimal market structure rather than providing evidence of lax screening by originators. Evidence from loan-level data supports the model’s predictions. Moreover structural estimation of the model shows specialized servicers were on average 40-70% more efficient in servicing the loans and this, on average, lowered by 20-40 bps the interest rate paid by borrowers with lower credit quality. Regulations banning the separation of servicer from originator would only exclude 1.5-2.5% of borrowers with the lowest quality -- but would result in higher interest rates for more than half of all subprime and Alt-A borrowers.
The Rise of CDOs and the Inferior Performance of Securitized Assets, joint with Adam Ashcraft and Kunal Gooriah
This paper investigates whether the rise of CDOs contributed to the lower performance of securitized assets by enabling asset securitizers to sell their equity holding in the securitized assets and reducing their “skin in the game”. We construct a comprehensive dataset of all commercial real estate CDOs (CRE CDO), all commercial mortgage backed securities (CMBS), and all of their underlying commercial loans since 1999. Deals in which securitizers sold a higher fraction of the equity tranche into a CRE CDO had worse performance. However investors in these bonds were not compensated for this lower performance. Constructing a loan level model of default, we show both lower credit enhancements and lower quality of underlying loans contributed to the weaker performance of these CMBS deals. A significant fraction of the surplus from risk-mispricing by investors was passed to commercial loan borrowers. In general our result highlights the importance of risk retention rules in reducing the extent of moral hazard in the securitization process.