Ebook Originate-to-Distribute Model and the Subprime Mortgage Crisis
The recent crisis in the mortgage market is having an enormous impact on the world economy. While the popular press has presented a number of anecdotes and case studies, a body of academic research is fast evolving to understand the precise causes and consequences of this crisis (see Greenlaw et al., 2008; Brunnermeier, 2008). Our study contributes to this growing literature by analyzing the effect of banks’ participation in the originate-to-distribute (OTD) method of lending on the crisis. We show that the transfer of credit risk through the OTD channel resulted in the origination of inferior quality mortgages. This effect was predominant among banks with relatively low capital and banks with lesser reliance on demand deposits.
As efficient providers of liquidity to both consumers and firms (Diamond and Dybvig, 1983; Holmstrom and Tirole, 1998; Kashyap, Rajan, and Stein, 2002), as better ex-ante screeners (Leland and Pyle, 1977; Boyd and Prescott, 1986), or as efficient ex-post monitors (Diamond, 1984), banks perform several useful functions to alleviate value relevant frictions in the economy. On the asset side of their balance sheet, they develop considerable expertise in screening and monitoring their borrowers to minimize the costs of adverse selection and moral hazard. It is possible that they are not able to take full advantage of these expertise due to market incompleteness, regulatory reasons, or some other frictions. For example, regulatory capital requirements and frictions in raising external capital might prohibit a bank from lending up to the first best level (Stein, 1998).
Financial innovations naturally arise as a market response to these frictions (Tufano, 2003; Allen and Gale, 1994). The originate-to-distribute (OTD) model of lending, where the originator of loans sells them to third parties, emerged as a solution to some of these frictions. This model allows the originating financial institution to achieve better risk sharing with the rest of the economy, economize on the regulatory capital, and achieve better liquidity risk management. Thus, banks can use this model to leverage their comparative advantages in loan origination.
These benefits of the OTD model come at a cost. As the lending practice shifts from the originate-to-hold to originate-to-distribute model, it begins to interfere with the originating banks’ ex-ante screening and ex-post monitoring incentives (Pennacchi, 1988; Gorton and Penacchi, 1995; Parlour and Plantin, 2008). It is this cost of the OTD model that lies at the root of our analysis. By separating the originator of a loan from the bearer of its ultimate default risk, the OTD model can dilute the screening incentives of the originating banks.
For example, if the originating bank is unable to credibly communicate the unobservable risk or soft information about a loan to its ultimate buyer, then the bank’s incentive to expend resources in screening gets diluted (see Rajan, Seru, and Vig, 2009 and Stein, 2002). Further, if the ultimate buyers are unable to understand the true risks of these loans due to some external frictions, then it is in the interest of the originating banks to lend without efficient (costly) screening. An example of such a friction is the potential rating mistakes made by credit rating agencies, which many investors rely upon.
In this paper, our goal is to understand whether participation in the OTD market resulted in the origination of excessively inferior quality mortgage loans as a result of the poor screening incentives of the originating banks. Our key hypothesis is that banks with aggressive involvement in the OTD market had incentives to issue inferior quality mortgages. This allowed them to benefit from the origination fees without bearing the credit risk of the borrowers.
As long as the secondary market for mortgage sale was functioning normally, they were able to easily offload these loans to third parties. When the secondary mortgage market came under pressure in the middle of 2007, banks with high OTD loans were stuck with relatively inferior quality mortgage loans. It can take about two to three quarters from the origination to the sale of these loans in the secondary market (Gordon and D’Silva, 2008). In addition, the originators typically guarantee the loan performance for the first ninety days of the loans (Mishkin, 2008). If banks with high OTD loans in the pre-disruption period were originating loans of inferior quality, then in the immediate post-disruption period such banks are likely to be left with a disproportionately large quantity of poor loans. We use the sudden drop in liquidity in the secondary mortgage market to identify the effect of OTD lending on the mortgage quality.
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