Securitization, Ratings, and Credit Supply

• Author: BRENDAN DALEY,VICTORIA VANASCO,BRETT GREEN
• Published date: 01 April 2020
• Date: 01 April 2020
• DOI: http://doi.org/10.1111/jofi.12866

THE JOURNAL OF FINANCE •VOL. LXXV, NO. 2 •APRIL 2020

Securitization, Ratings, and Credit Supply

BRENDAN DALEY, BRETT GREEN, and VICTORIA VANASCO∗

ABSTRACT

We develop a framework to explore the effect of credit ratings on loan origination.

We show that ratings endogenously shift the economy from a signaling equilibrium,

in which banks inefficiently retain loans to signal quality, toward an originate-to-

distribute equilibrium with zero retention and inefficiently low lending standards.

Ratings increase overall efficiency, provided that the reduction in costly retention

more than compensates for the origination of some negative net present value loans.

We study how banks’ ability to screen loans affects these predictions and use the

model to analyze commonly proposed policies such as mandatory “skin in the game.”

ASSET-BACKED SECURITIZATION IS AN IMPORTANT driver of credit supply (Lout-

skina and Strahan (2009), Shivdasani and Wang (2011)). In the United States,

since the mid-1990s, there has been substantial growth in the securitization

of many asset classes, including mortgages, student loans, commercial loans,

auto loans, and credit card debt. This practice has financed between 30% and

75% of loan amounts in these consumer lending markets (Gorton and Metrick

(2013)), significantly increasing households’ access to credit. The development

of markets for securitized products has been facilitated in part by credit rating

agencies (CRAs), which allow issuers access to a large pool of investors who

would otherwise have perceived these securities as opaque and complex (Coval,

Jurek, and Stafford (2009), Pagano and Volpin (2010)).

∗Brendan Daley is at Johns Hopkins University. Brett Green is at Washington University in

St. Louis. Victoria Vanasco is at Centre de Recerca en Economia Internacional (CREI), UPF, and

Barcelona GSE. Brett Green gratefully acknowledges support from the Fisher Center for Real

Estate and Urban Economics. The authors are grateful to Philip Bond, an anonymous associate

editor, and two anonymous referees for their valuable feedback and suggestions. We thank Bar-

ney Hartman-Glaser, Joel Shapiro, Anjan Thakor,Pablo Ruiz Verd ´

u, and Alessio Piccolo for their

thoughtful discussions. We are also grateful to seminar participants at Stanford GSB, CREI, Uni-

versitat Pompeu Fabra, CU Boulder, New York University,London School of Economics, Banco de

Portugal, University of North Carolina at Chapel Hill, Bendheim Center for Finance at Prince-

ton University, Washington University at St. Louis, McCombs School of Business at UT Austin,

Carlson School of Management at the University of Minnesota, Imperial College, London Business

School, ToulouseSchool of Economics, HEC Paris, and Wharton School of Business; and conference

participants at MADBAR, EIFE Junior Conference in Finance and the Economics of Credit Rat-

ings Conference at Carnegie Mellon, the Workshop on Corporate Debt Markets at Cass Business

School, NBER Corporate Finance Meeting, FIRS, Barcelona Summer Forum, and Oxford FIT for

helpful feedback and suggestions. We have read The Journal of Finance disclosure policy and have

no conflicts of interest to disclose.

DOI: 10.1111/jofi.12866

C2019 the American Finance Association

1037

1038 The Journal of Finance R

In the aftermath of the recent financial crisis, the practice of securitization

has been under intense scrutiny.The roles of originators in screening loans and

of rating agencies in evaluating securitized products have come into question.1

A variety of regulations have been proposed in an attempt to discipline loan

origination and protect investors. For example, the Dodd-Frank Act imposed a

mandatory “skin-in-the-game” rule on securitizers and established disclosure

requirements on both securitizers and rating agencies. Clearly, there are im-

portant interactions between the accuracy of information available to investors,

banks’ decisions with respect to which loans to originate, and the market for

securities backed by these loan pools. Yet, surprisingly, the academic literature

has little to say about these interactions.

In this paper, we propose a stylized model of origination and securitization

to analyze the role of both public and private information. We then explore

the implications for lending standards, credit supply, and welfare. Our main

finding is that the availability of public information, such as credit ratings,

improves the allocation of cash flow rights but reduces lending standards and

can lead to an oversupply of credit. Despite the potential for an oversupply

of credit, in most cases, total welfare increases with rating accuracy. We also

illustrate how the effectiveness of banks’ screening technology influences the

effect of ratings. With a better understanding of these forces, we investigate

the effects of common policy proposals, such as those described above from the

Dodd-Frank Act.

The model features a continuum of banks and a set of competitive and fully

rational investors. Each bank has access to a loan pool and uses a screening

technology to acquire private information about the quality of its loans.2Each

bank then decides whether to fund its pool—the origination stage. Following

origination, banks have an incentive to reallocate the cash flow rights from

their loan pool to investors (e.g., due to capital constraints) and do so by selling

securities backed by their loan pool in the secondary market—the securitiza-

tion stage. In this stage, the bank’s private information hinders the efficient

allocation of cash flow rights, which, in turn, distorts its incentives during the

origination stage.

The model admits two channels through which information can be conveyed

to investors to mitigate these distortions. First, because it is more costly for a

bank to retain bad loans than good ones, retention may serve to signal quality

to investors as in Leland and Pyle (1977). Banks’ ability to signal through

retention is consistent with evidence in Begley and Purnanandam (2017)

and Ivashina (2009), who study the markets for residential mortgage-backed

1See Dell’Ariccia, Igan, and Laeven (2012), Keys et al. (2010), Jaffee et al. (2009), Mian and Sufi

(2009), and Agarwal, Chang, and Yavas (2012) for how securitization negatively affects lending

standards, and Pagano and Volpin (2010) and Benmelech and Dlugosz (2010) for the role, and

failures, of CRAs in the securitization process.

2The assumption that banks acquire private information about borrowers at the loan screening

stage is consistent with findings in Mikkelson and Partch (1986), Lummer and McConnell (1989),

Slovin, Sushka, and Polonchek (1993), Degryse and Ongena (2005), Plantin (2009), Agarwal and

Hauswald (2010), and Botsch and Vanasco (2019).

Securitization, Ratings, and Credit Supply 1039

securities (RMBS) and syndicated loans, respectively.3Second, information

about the pool of loans underlying each security can be conveyed to investors

through a noisy public signal about the quality of the underlying collateral. We

refer to this signal as a rating, but it can be interpreted more broadly as any

form of public information. This rating is observed after the bank’s retention

decision but prior to the sale of the security. The primary question that we seek

to answer is how ratings affect lending standards and the supply of credit.

Toaddress this question, it is useful to describe the benchmark model without

ratings. Absent ratings or the release of other public information, the securiti-

zation stage is a standard signaling game where (least-cost) separation is the

unique stable outcome. Banks retain a positive fraction of the loan they issue

if they originated a good pool and sell 100% of their loan if they originated

a bad pool. By doing so, investors learn the quality of each loan sold on the

secondary market and prices fully reflect all available information. However,

because retention is costly,the bank does not realize the full social value of good

loans, which leads to inefficiently high lending standards and an undersupply

of credit.

When informative ratings are available, banks that originate good loan pools

no longer fully separate through retention. Instead, there is some degree of pool-

ing at a lower retention level.4Since retention is inefficient, ratings improve

allocative efficiency in the securitization stage.5But, because less is retained

and ratings are imperfect, their introduction actually reduces banks’ lending

standards and may induce an oversupply of credit. In essence, when ratings

are introduced, the equilibrium of the securitization stage endogenously shifts

from a signaling-through-retention equilibrium to an originate-to-distribute

(OTD) equilibrium, where banks forgo signaling and sell 100% of the loans

they originate.

There are two potential sources of inefficiency in our model. First, cash flow

retention may be inefficiently high due to asymmetric information at the se-

curitization stage, which induces banks to engage in costly signaling. Second,

lending standards may be inefficiently high or low since banks do not neces-

sarily internalize the social value of the loans they originate. More accurate

ratings reduce costly retention, but may also induce inefficiently low lending

standards. Therefore, ratings increase ex-ante efficiency,provided that the ben-

efits of reduced retention outweigh the costs of originating negative net present

value (NPV) loans. We show that these benefits necessarily outweigh the costs

when bank screening technology is sufficiently effective. Further, as ratings

3Adelino, Gerardi, and Hartman-Glaser (2019) find evidence of banks signaling their private

information about RMBS deals by delaying trade—a different form of cash flow retention that

could be studied within our context as well.

4A similar feature is present in Hartman-Glaser (2017), who shows that when sellers are able to

signal through both retention and reputation (as opposed to with a public signal), the equilibrium

is no longer separating.

5This result is consistent with empirical evidence that increased third-party certification, such

as ratings or number of analysts, increases a firm’s debt issuances and sometimes equity issuances

(Faulkender and Petersen (2005), Sufi (2007), Derrien and Kecsk´

es (2013)).