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Financial regulation and securitization: Evidence from subprime loans

  • Keys, Benjamin J.
  • Mukherjee, Tanmoy
  • Seru, Amit
  • Vig, Vikrant

We examine the consequences of existing regulations on the quality of mortgage loans originations in the originate-to-distribute (OTD) market. The information asymmetries in the OTD market can lead to moral hazard problems on the part of lenders. We find, using a plausibly exogenous source of variation in the ease of securitization, that the quality of loan origination varies inversely with the amount of regulation: more regulated lenders originate loans of worse quality. We interpret this result as a possible evidence that the fragility of lightly regulated originators' capital structure can mitigate moral hazard. In addition, we find that incentives which require mortgage brokers to have [`]skin in the game' and stronger risk management departments inside the bank partially alleviate the moral hazard problem in this setting. Finally, having more lenders inside a mortgage pool is associated with higher quality loans, suggesting that sharper relative performance evaluation made possible by more competition among contributing lenders can also mitigate the moral hazard problem to some extent. Overall, our evidence suggests that market forces rather than regulation may have been more effective in mitigating moral hazard in the OTD market. The findings caution against policies that impose stricter lender regulations which fail to align lenders' incentives with the investors of mortgage-backed securities.

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Article provided by Elsevier in its journal Journal of Monetary Economics.

Volume (Year): 56 (2009)
Issue (Month): 5 (July)
Pages: 700-720

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Handle: RePEc:eee:moneco:v:56:y:2009:i:5:p:700-720
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/505566

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  1. Benjamin J. Keys & Tanmoy Mukherjee & Amit Seru & Vikrant Vig, 2010. "Did Securitization Lead to Lax Screening? Evidence from Subprime Loans," The Quarterly Journal of Economics, MIT Press, vol. 125(1), pages 307-362, February.
  2. Douglas W. Diamond & Raghuram G. Rajan, . "Liquidity Risk, Liquidity Creation and Financial Fragility: A Theory of Banking," CRSP working papers 476, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  3. Souphala Chomsisengphet & Anthony Pennington-Cross, 2006. "The evolution of the subprime mortgage market," Review, Federal Reserve Bank of St. Louis, issue Jan, pages 31-56.
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  7. Robert Gibbons & Kevin Murphy, 1989. "Relative Performance Evaluation for Chief Executive Officers," Working Papers 628, Princeton University, Department of Economics, Industrial Relations Section..
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