Risk-Taking and Asset-Side Contagion in an Originate-to-Distribute Banking Model

In a model of originate-to-distribute (OTD) banking, I show that contagion may spread before any preference shock, fire sale, or change in lending margins takes place. The drivers of contagion are opaqueness of collateral and roll-over frequency. Complexity of structured finance and poor screening of noninstitutional borrowers induce both originators and investors at different stages of the OTD chain to develop heterogeneous expectations on the future value of securitized debt. When new information on the value of collateral is sufficiently bad, overleveraged banks are unable to repay loans and the supply of liquidity by lenders in the money market shrinks in the short term. Banks with accurate pricing models are unable to roll over their collateralized loans and go bankrupt for lack of liquidity. Under some conditions the industry is able to prevent contagion to solvent institutions. In the scenario where that is not feasible, policy makers shall limit their intervention to ensuring orderly resolution of insolvent banks’ default.