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Why Did U.S. Banks Invest in Highly-Rated Securitization Tranches?

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  • Erel, Isil

    (OH State University)

  • Nadauld, Taylor

    (Brigham Young University)

  • Stulz, Rene M.

    (OH State University)

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    Abstract

    We estimate holdings of highly-rated tranches of mortgage securitizations of American deposit-taking banks ahead of the credit crisis and evaluate hypotheses that have been advanced to explain these holdings. We find that holdings of highly-rated tranches were economically trivial for the typical bank, but banks with greater holdings performed more poorly during the crisis. Though univariate comparisons show that banks with large trading books had greater holdings, the holdings of highly-rated tranches are not higher for banks with large trading books in regressions that control for bank size. The ratio of highly-rated tranches holdings to assets increases with bank assets, but not for banks with more than $50 billion of assets. This evidence is inconsistent with explanations for holdings of highly-rated tranches that emphasize the incentives of banks deemed "too-big-to-fail". Further, the evidence does not provide support for "bad incentives" theories of holdings of highly-rated tranches. We find, however, that banks active in securitization held more highly-rated tranches. Such a result can be consistent with regulatory arbitrage as well as with securitizing banks holding highly-rated tranches to convince investors of the quality of these securities. Our evidence supports the latter hypothesis.

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    Bibliographic Info

    Paper provided by Ohio State University, Charles A. Dice Center for Research in Financial Economics in its series Working Paper Series with number 2011-16.

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    Date of creation: Jul 2011
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    Handle: RePEc:ecl:ohidic:2011-16

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    Cited by:
    1. Joseph P. Hughes & Loretta J. Mester, 2013. "Who said large banks don’t experience scale economies? Evidence from a risk-return-driven cost function," Working Papers 13-13, Federal Reserve Bank of Philadelphia, revised 04 Feb 2014.

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