Design of Financial Securities: Empirical Evidence from Private-Label RMBS Deals

Abstract

Using a representative sample of Residential Mortgage-Backed Securities (RMBS), we show that deal sponsors use the equity tranche as a signal of the unobserved quality of opaque pools. Deals with higher level of equity tranche have significantly lower foreclosure rates that cannot be explained away by observable credit risk or correlation structure of the loans in the underlying pool. Further, we analyze trade-offs that are unique to bundling and tranching of loans in securitization deals as compared to the sale of a single asset. Consistent with DeMarzo's (2005) model, we show that the extent of AAA-rated tranche is significantly higher for pools that bundle loans with commonality in their private information but with uncorrelated risks. Overall, we uncover some of the key economic drivers of RMBS design and document contracting frictions that the design was able to mitigate even during the peak of the subprime mortgage market.

The Effect of Large Investors on Asset Quality: Evidence from Subprime Mortgage Securities

“…Consistent with a private information story, we show that the difference in ex-post performance between loans in GSE and non-GSE pools primarily comes from low documentation loans, where soft information has been found to be especially important (Jiang Nelson Vytlacil, 2014a, 2014bKeys, Seru, and Vig, 2012;Begley and Purnanandum 2013;Saengchote, 2013). The difference in default rates between GSE and non-GSE pools up to the end of 2008 is 3.9 percentage points, whereas the difference for full documentation loans is only 0.7 percentage points.…”

“…The existing literature has argued that low documentation lending is the segment of the market where banks putting together the deals are most likely to have private information that could lead to systematically differential performance across mortgage pools that is not accounted for by observable loan characteristics (e.g. Keys, Seru and Vig, 2012;Saengchote, 2013;Begley and Purnanandum 2013;Vytlacil, 2014a, 2014b).…”

“…Several studies have analyzed whether securitization gives rise to moral hazard in terms of originator screening incentives (Keys, Mukherjee, Seru, and Vig, 2010;Purnanandam, 2011;Keys, Seru and Vig, 2012;Bubb and Kaufman, 2014), as well as the observable risk characteristics of securitized loans and portfolio loans (Ambrose et al, 2005;Krainer and Laderman, 2009;Elul, 2011;Agarwal, Chang and Yavas, 2012;and Jiang, Nelson, and Vytlacil 2014b). Importantly, investors understand the misaligned incentives associated with securitization, and protect themselves from these frictions through contracting features (e.g., by requiring representations and warranties about loan quality), security design features (e.g., requiring higher subordination levels) or required risk premia (Begley and Purnanandum 2013). Issuers of securities, on the other hand, have incentives to signal higher loan quality through risk retention (e.g., DeMarzo, 2005), vertical integration with originators (Demiroglu and James, 2013), and ultimately through reputation-building (Albertazzi, Eramo, Gambacorta, and Salleo, 2014).…”

Skin-in-the-Game in ABS Transactions: A Critical Review of Policy Options

“…Keys et al (2010) find evidence for a negative impact of securitization (likelihood) on ex-ante screening effort by the issuer. Begley and Purnanandam (2013) and Ashcraft et al (2014) They find an inverse relationship between the size of the equity tranche and the level of foreclosure experienced among borrowers in the asset pool. Based on 483 CMBS deals issued in between 1995 and 2010, Ashcraft et al (2014) find similarly the probability of senior tranche default to be inversely related to the size of the first loss piece.…”

Securitization Structures and Security Design

“…The right balance between debt and equity can be struck when there are information asymmetries. Empirical evidence on the design of structured securities as debt rather than equity is discussed in Begley and Purnanandam (2017), in Park (2013) for mortgages and in Franke, Herrmann, and Weber (2012) for CDOs. Research has also shown there were various types of market imperfections that could justify more complex structuring, among them asymmetric information, market incompleteness, and transaction costs. Looking at the optimal design of debt contracts, Diamond (1993) showed that both maturity and seniority could be optimally engineered in order to alleviate the negative effects of information asymmetries, but in a context including refinancing and control takeover that is not applicable to securitized products.…”