Securitization, converting illiquid assets into liquid securities, has grown tremendously in recent years, with the securitized universe of mortgage loans reaching $3.6 trillion in 2006. The option to sell loans to investors has transformed the traditional role of financial intermediaries in the mortgage market from “buying and holding” to “buying and selling.” The perceived benefits of this financial innovation, such as improving risk sharing and reducing banks’ cost of capital, are widely cited (Pennacchi 1988). However, in light of the 50% increase in delinquencies in the heavily securitized subprime housing market from 2005 to 2007, critiques of the securitization process have gained increased prominence (Stiglitz 2007).
The rationale for these concerns derives from theories of financial intermediation. Delegating monitoring to a single lender avoids the problems of duplication, coordination failure, and free-rider problems associated with multiple lenders (Diamond 1984). However, in order for a lender to screen and monitor, it must be given appropriate incentives (Holmstrom and Tirole 1997) and this is provided by the illiquid loans on their balance sheet (Diamond and Rajan 2003). By creating distance between a loan’s originator and the bearer of the loan’s default risk, securitization potentially reduces lenders’ incentives to carefully screen and monitor borrowers (Petersen and Rajan 2002). On the other hand, proponents of securitization argue reputation concerns or regulatory oversight may prevent moral hazard on the part of lenders. What the effects of securitization on screening are, thus, remains an empirical question.
This paper investigates the relationship between securitization and screening standards in the context of subprime mortgage-backed securities. The challenge in making a causal claim is the difficulty in isolating differences in loan outcomes independent of contract and borrower characteristics. First, in any cross-section of loans, those which are securitized may differ on observable and unobservable risk characteristics from loans which are kept on the balance sheet (not securitized). Second, in a time-series framework, simply documenting a correlation between securitization rates and defaults may be insufficient. This inference relies on precisely establishing the optimal level of defaults at any given point in time, a demanding econometric exercise. Moreover, this approach ignores macroeconomic factors and policy initiatives which may be independent of lax screening and yet may induce compositional differences in mortgage borrowers over time. For instance, house price appreciation and the changing role of Government-Sponsored Enterprises (GSEs) in the subprime market may also have accelerated the trend toward originating mortgages to riskier borrowers in exchange for higher payments.
We overcome these challenges by exploiting a rule of thumb in the lending market which induces exogenous variation in the ease of securitization of a loan compared to a loan with similar characteristics. This rule of thumb is based on the summary measure of borrower credit quality known as the FICO score. Since the mid-1990s, the FICO score has become the credit indicator most widely used by lenders, rating agencies, and investors. Underwriting guidelines established by the GSEs, Fannie Mae and Freddie Mac, standardized purchases of lenders’ mortgage loans and cautioned against lending to borrowers with FICO scores below 620. While the GSEs actively securitized loans when the nascent subprime market was relatively small, since 2000 this role has shifted entirely to investment banks and hedge funds (the non-agency sector). We argue that persistent adherence to this ad-hoc cutoff by investors who purchase securitized pools from non-agencies generates a differential increase in the ease of securitization for loans. That is, loans made to borrowers which fall just above the 620 credit cutoff have a higher unconditional likelihood of getting securitized and are therefore more liquid relative to loans below this cutoff.
To evaluate the effect of securitization on screening decisions, we examine the performance of loans originated by lenders around this threshold. As an example of our design, consider two borrowers, one with a FICO score of 621 (620+) while the other has a FICO score of 619 (620?), who approach the lender for a loan. In order to evaluate the quality of the loan applicant, screening involves collecting both “hard” information, such as the credit score, and “soft” information, such as a measure of future income stability of the borrower. Hard information by definition is something that is easy to contract upon (and transmit), while the lender has to exert an unobservable effort to collect soft information (Stein 2002). We argue that the lender has a weaker incentive to base origination decisions on both hard and soft information, less carefully screening the borrower, at 620+ where there is a higher likelihood that this loan will be eventually securitized. In other words, because investors purchase securitized loans based on hard information, the cost of collecting soft information are internalized by lenders to a lesser extent when screening borrowers at 620+ than at 620?. Therefore, by comparing the portfolio of loans on either side of the credit score threshold, we can assess whether differential access to securitization led to changes in the behavior of lenders who offered these loans to consumers with nearly identical risk profiles.
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