Credit enhancement mechanism in loan securitization and its implication to systemic risk

Using US BHC data for the period from 2004 to 2016, this paper examines the relationship between different forms of credit enhancement and bank contribution to systemic crashes. The findings demonstrate that the overall level of contractual retained interests and guarantees offered to own securitization structures poses a significant threat to financial system stability, although this varies for different types of the underlying assets as well as subordinated structure of interest retention. The amount of credit exposure arising from credit enhancements increases BHCs’ contribution to market crashes, while ownership interest in loans and obligations to provide funding do not seem to affect the level of risk BHCs inject into the system. Recourse credit enhancement in mortgage and consumer securitizations is a significant determinant of systemic risks injected by banks into the market with the former one having the strongest economic impact. The implicit credit enhancement in commercial loans tends to decrease systemic risk contribution. The results are not driven by the level of securitization activities, although the economic effect is stronger for large securitizers. The findings have direct implications for the most recent changes in legislation requiring originating banks to retain a material portion of credit risks of securitized loans through retained interests mechanisms.