Securitization, bank vigilance, leverage and sudden stops

Patir, Assaf (2017): Securitization, bank vigilance, leverage and sudden stops.

Abstract

Accounts of the recent financial crisis claim that the practice of securitizing bank loans had led banks to be less vigilant in their lending habits. Securitization, the argument goes, gives the originators of the loans worse incentives to screen potential borrowers and monitor them as compared to traditional direct lending. But, unless investors are pricing securities irrationally, wouldn't contract theory suggest that banks should always prefer the contract that allows them to commit to higher vigilance?

This paper addresses this problem by introducing a model in which securitization leads to laxer lending standards, even though it is chosen optimally by banks and investors. I construct a model where investment is performed through intermediaries (banks) that choose the volume of lending and a variable level of effort in screening potential borrowers, set the lending standards, and can finance their activities either by eliciting deposits or selling securities. Securitization allows the banks to credibly communicate to investors information about the borrowers, which depositors cannot access.

Securitization has two effects: at fixed leverage, securitization gives banks better incentives to screen borrowers and leads to higher lending standards; however, it also allows banks to choose a higher level of leverage, which in turn degrades the screening effort. In equilibrium, securitization leads to lower vigilance, but is still preferred because it allows the banks to intermediate more funds. Paradoxically, the method of finance that allows banks to better communicate information about borrowers leads in equilibrium to less information being produced.

The model also provides a natural explanation for why securitization is not observed below a strict credit rating cutoff (FICO 620), and why securitization activity can discontinuously stop as a continuous function of overall economic conditions.

• Item Type: MPRA Paper
• Language: English
• Keywords: securitization, leverage, banks, SPV, MBS, sudden stops
• Subjects: E - Macroeconomics and Monetary Economics > E2 - Consumption, Saving, Production, Investment, Labor Markets, and Informal Economy > E22 - Investment ; Capital ; Intangible Capital ; Capacity; G - Financial Economics > G1 - General Financial Markets > G14 - Information and Market Efficiency ; Event Studies ; Insider Trading; G - Financial Economics > G1 - General Financial Markets > G18 - Government Policy and Regulation; G - Financial Economics > G2 - Financial Institutions and Services > G21 - Banks ; Depository Institutions ; Micro Finance Institutions ; Mortgages

References

X. An, Y. Deng, and S. Gabriel. Value creation through securitization: Evidence from the cmbs market. Journal of Real Estate Finance and Economics, 38:302-326, 2009.

A. B. Ashcraft and T. Schuermann. Understanding the securitization of subprime mortgage credit. Foundations and Trends in Finance, 2(3):191-309, July 2008.

L. M. Benveniste and A. N. Berger. Securitization with recourse : An instrument that offers uninsured bank depositors sequential claims. Journal of Banking & Finance, 11 (3):403 - 424, 1987.

G. Caprio, Jr., A. Demirguec-Kunt, and E. J. Kane. The 2007 meltdown in structured securitization: Searching for lessons, not scapegoats. World Bank Res. Observ., 25(1): 125-155, Feb 2010.

C. Cumming. The economics of securitization. Federal Reserve Bank of New York Quarterly Review, 12(3):11, October 1987.

G. Dell'Ariccia, D. Igan, and L. Laeven. Credit booms and lending standards: Evidence from the U.S. subprime mortgage market. IMF Working Paper WP 08/106, 2008.

P. DeMarzo. The pooling and tranching of securities: A model of informed intermediation. Review of Financial Studies, 18(1):1-35, 2005.

C. Downing, D. Jaffee, and N. Wallace. Is the market for mortgage-backed securities a market for lemons? Review of Financial Studies, 22:2457-2494, 2009.

R. Elul. Securitization and Mortgage Default. Journal of Financial Services Research, 49 (2-3):281-309, June 2016.

I. Fender and J. Mitchell. Securitization and mortgage default. Bank of International Settelments Working Papers No 289, 2009.

M. J. Flannery. Capital regulation and insured banks choice of individual loan default risks. J. of Monetary Econ., 24(2):235 - 258, 1989.

G. Franke and J. P. Krahnen. Default Risk Sharing between Banks and Markets: The Contribution of Collateralized Debt Obligations. In The Risks of Financial Institutions, NBER Chapters, pages 603-634. University of Chicago Press, Jan. 2007.

M. Gertler, N. Kiyotaki, and A. Prestipino. Wholesale banking and bank runs in macroe conomic modeling of financial crises. Handbook of Macroeconomics, 2:1345 - 1425, 2016.

G. Gorton. The Subprime Panic. European Financial Management, 15(1):10-46, Jan. 2009.

G. Gorton and G. Pennacchi. Banks and loan sales - marketing nonmarketable assets. J. of Monetary Econ., 35(3):389-411, June 1995.

G. B. Gorton and A. Metrick. Securitization. In G. Constantinides, M. Harris, and R. M. Stulz, editors, Handbook of the Economics of Finance. forthcoming., 2012.

G. B. Gorton and N. S. Souleles. Special purpose vehicles and securitization. In The Risks of Financial Institutions, NBER Chapters, pages 549-602. National Bureau of Economic Research, Inc, Summer 2007.

S. I. Greenbaum and A. V. Thakor. Bank funding modes : Securitization versus deposits. Journal of Banking and Finance, 11(3):379-401, 1987. J. Han, K. Park, and G. Pennacchi. Corporate Taxes and Securitization. Journal of Finance, 70(3):1287-1321, 2015.

F. S. Iachan, P. T. Nenov, and A. Simsek. The Choice Channel of Financial Innovation. Technical report, NBER, Oct. 2015.

C. James. The use of loan sales and standby letters of credit by commercial banks. Journal of Monetary Economics, 22(3):395 - 422, 1988.

J. H. Kareken. The emergence and regulation of contingent commitment banking. Journal of Banking and Finance, 11(3):359 - 377, 1987.

B. J. Keys, T. Mukherjee, A. Seru, and V. Vig. Financial regulation and securitization: Evidence from subprime loans. Journal of Monetary Economics, 56(5):700 - 720, 2009.

B. J. Keys, T. Mukherjee, A. Seru, and V. Vig. Did securitization lead to lax screening? evidence from subprime loans. QJE, 125(1):307-362, Feb 2010.

B. J. Keys, A. Seru, and V. Vig. Lender Screening and the Role of Securitization: Evidence from Prime and Subprime Mortgage Markets. Review of Financial Studies, 25(7):2071- 2108, 2012.

A. Mian and A. Sufi. The Consequences of Mortgage Credit Expansion: Evidence from the U.S. Mortgage Default Crisis. The Quarterly Journal of Economics, 124(4):1449-1496, 2009.

A. Mian and A. Sufi. Fraudulent Income Overstatement on Mortgage Applications During the Credit Expansion of 2002 to 2005. The Review of Financial Studies, 30(6):1832-1864, June 2017. ISSN 0893-9454.

C. A. Parlour and G. Plantin. Loan sales and relationship banking. J. Financ., 63(3): 1291-1314, Jun 2008.

G. G. Pennacchi. Loan sales and the cost of bank capital. The Journal of Finance, 43(2): 375-396, June 1988.

A. Purnanandam. Originate-to-distribute Model and the Subprime Mortgage Crisis. Review of Financial Studies, 24(6):1881-1915, June 2011. ISSN 0893-9454, 1465-7368.

K. Schipper and T. L. Yohn. Standard-setting issues and academic research related to the accounting for financial asset transfers. Accounting Horizons, 21(1):59 - 80, 2007.

R. M. Townsend. Optimal contracts and competitive markets with costly state verification. Journal of Economic Theory, 21(2):265-293, October 1979.