Center for Financial Innovation and Stability

Notes from the Vault
W. Scott Frame
April 2017

Securitization is a widely used form of financial intermediation that typically involves pooling loans and then issuing securities representing claims to the cash flows of these financial assets. This process may create value for lenders and investors through improved liquidity, capital management, and asset diversification; and for borrowers through expanded credit availability. But securitization also entails breaking apart the lending process into its component parts and, by doing so, creates conflicts of interest.

This Notes from the Vault synthesizes recent empirical research aimed at studying whether conflicts of interest in securitization contributed to the recent U.S. housing crisis by masking the riskiness of mortgages that were packaged for outside investors. A more complete discussion of these issues may be found in my recent working paper.

Securitization and the crisis
The U.S. housing crash resulted in massive losses to investors in mortgage-backed securities and triggered the global financial crisis, which itself ultimately led to the Great Recession. While most observers acknowledge that the U.S. housing crisis and the global financial crisis were the product of multiple causes, one commonly cited culprit is conflicts of interest inherent in securitization. Specifically, lenders may have better information about loan quality than outside investors (known as adverse selection problem) and/or weaker incentives to properly screen, monitor, and/or resolve securitized loans (referred to as moral hazard problems). Indeed, such asymmetric information problems are central features of economic theories explaining loan sales and securitization. But these issues have importantly been long understood by market participants who attempt to mitigate them through the use of various legal constructs (such as representations and warranties, pooling and servicing agreements) and countervailing economic incentives (such as functional integration, reputation building through repeated interaction, and risk retention).

The Financial Crisis Inquiry Commission's 2011 report pointed to the importance of securitization-based incentive conflicts when it concluded that: "The originate-to-distribute model [of securitization] undermined responsibility and accountability for the long-term viability of mortgages and mortgage-related securities and contributed to the poor quality of mortgage loans." A belief that conflicts of interest in securitization were a significant problem also previously led the G20 to conclude in 2009 that "Securitization sponsors or originators should retain a part of the risk of the underlying assets, thus encouraging them to act prudently." This declaration was followed by member nations imposing risk retention requirements on asset securitizations executed in their jurisdictions. Perhaps ironically, the vast majority of mortgage securitizations were exempted in the final U.S. rules.

U.S. residential mortgage securitization
The U.S. secondary mortgage market can generally be segmented into three parts based on borrower and loan characteristics: government, conventional conforming, and conventional non-conforming. The "government market" refers to loans carrying government mortgage insurance (like Federal Housing Administration, or FHA), and virtually all of these loans are securitized through Ginnie Mae. Conventional-conforming mortgages are those eligible to be purchased or securitized by either Fannie Mae or Freddie Mac, which are two government-sponsored enterprises (GSEs) that were placed into federal conservatorship during the financial crisis. The term "conforming" relates to legal limitations on eligible mortgage size and a required 20 percent down payment or equivalent credit enhancements such as private issued mortgage insurance.

Ginnie Mae, Fannie Mae, and Freddie Mac each provide blanket guarantees on the mortgage-backed securities (MBS) that they issue; collectively, these securities are typically referred to as "agency MBS." U.S. government backing (actual or perceived) eliminates an agency conflict for investors with respect to these securitizers, although the three institutions still face an adverse selection problem with lenders. However, the monopolist role of Ginnie Mae in the government market and the duopoly of Fannie Mae and Freddie Mac in the conventional-conforming market should naturally allow the three securitizers to more aggressively enforce contracting provisions (including rescinding access to the programs).

The conventional non-conforming (that is, private) residential mortgage market was historically composed (almost exclusively) of loans that simply exceeded the conforming loan limit—referred to as "jumbo mortgages." When these loans are securitized, the structure is generally like that of other consumer credit products: lenders work with an investment bank to create a set of securities backed by a loan pool—with security cash flows structured and prioritized for different investor classes. A simple stylized example would be the creation of a subordinate security that would be first to absorb losses from borrower defaults and a senior security that would be shielded from losses until the subordinate security was exhausted.

As U.S. home prices grew in the early 2000s, residential mortgage credit supply expanded to meet the credit demands of marginal borrowers; and the once niche segments of subprime and low-documentation (or "Alt-A") mortgage lending became mainstream. (Subprime mortgages are typically those with a very low or no down payments to households with poor credit, while low-documentation mortgages were traditionally for households with a down payment and good credit, but volatile or difficult to verify income.) Once obscure loan products, such as those with negative amortization or interest-only features, also became popular in an effort to improve home affordability. Virtually all of these mortgages were securitized. In order to compensate investors for the increased risk, pools with lower-quality loans were required to fund more of the pool with subordinated securities that carried higher interest rates.

Based on the S&P CoreLogic Case-Shiller National House Price Index, U.S. house prices peaked in July 2006 and soon began a precipitous decline, falling over 27 percent over the next five and one-half years. A large fraction of mortgage borrowers—especially recent subprime and Alt-A borrowers—quickly found themselves in a position of "negative equity" (having the mortgage balance exceed the value of the property). Negative equity is considered to be a necessary condition for mortgage default, as borrowers could otherwise avoid default by selling their house for a profit. The rapid decline in home prices and wave of mortgage defaults decimated the private mortgage securitization market in 2007—a state from which it has not recovered.

Given the rapid growth and subsequent massive losses in the private residential mortgage securitization market, many have speculated that the conflicts of interest inherent in securitization were to blame. However, investors knew about these conflicts and tried to mitigate them in a variety of ways. Moreover, U.S. house prices had fallen precipitously and wiped out the limited equity in many recently originated mortgages. Whether and to what extent securitization is to blame for the losses is ultimately an empirical question that several recent research papers have explored from a variety of angles.

Academic studies
The first question studied by academics is a straightforward one: are observably riskier loans more likely to be securitized? A review of these papers suggests lenders tend to transfer less risky loans to Fannie Mae and Freddie Mac, but that the association between loan risk and privately securitized mortgages is mixed. However, the loan risk characteristics examined (such as credit scores, loan-to-value ratios, and product types) are observable to investors. As a result, this type of analysis actually tell us little about conflicts of interest in securitization, since adverse selection and moral hazard are theories based on the presence of private information (that is, information observable to the lender but not to the securitizer or investor).

Another set of papers take the next step and ask: are securitized loans more likely to default as compared to loans retained by lenders, after controlling for observed loan risk factors? The idea is to measure a "treatment effect" of securitization, which may be interpreted as reflecting unobserved private information about loan quality or underwriting effort. While loans securitized with Fannie Mae or Freddie Mac seem to perform at least as well as similar portfolio loans, the literature again provides mixed results in terms of mortgage default and private-label securitization. One key finding for private securitization is that loan seasoning, or requiring lenders to hold the loan for a spell prior to securitization, was an important way to combat private information about loan quality. A critical omission in all but one of these studies is the borrowers' house prices experience. As discussed above, falling home prices can result in borrowers finding themselves in a position of negative equity, which places them at significantly higher risk of default.

Another set of papers use a securitization rule of thumb—borrowers' FICO credit score being above or below 620—to examine whether securitization reduces lender screening incentives due to moral hazard. The idea here is that, for many years, industry participants believed that a 620 FICO score represented the floor for securitization eligibility. While researchers concur about the existence of the industry rule of thumb, there is significant disagreement about whether this guidance actually induced lessened or heightened screening of marginal loans. Furthermore, any evidence of heightened risk associated with securitization seems to be confined to low-documentation mortgages—those that are lightly screened by definition.

A final group of papers look at whether investors in the private-label mortgage securitization market recognized the attendant risks, particularly as it pertained to low-documentation loans. One paper shows that, holding other observed loan characteristics constant, the proportion of low-documentation mortgages in a securitization deal was positively related to the size of the subordinated tranches. This suggests that investors recognized the heightened fraud risk associated with such loans. Related research also suggests that lender affiliation with securitization sponsors was an important way to reduce incentive conflicts, particularly in regard to the underwriting of low-documentation mortgages. This result manifested itself in security yields at the time of sale, as well as subsequent loan performance. Furthermore, one paper finds that low-documentation mortgages included in private-label securities purchased by Fannie Mae/Freddie Mac performed significantly better than similar loans in the same deal purchased by other investors. This is consistent with securitization sponsors catering to the largest investors in the private-label securitization market.

Conclusion
Taken together, recent empirical research for the U.S. home mortgage market suggests that securitization itself may not have been a significant problem, but rather the origination and distribution of observably riskier loans. Low-documentation mortgages, for which information problems are acute, performed especially poorly during the crisis. Securitized low-documentation mortgages performed better when included in deals where security issuers were affiliated with lenders or had significant reputational capital at stake; investors priced the risk of low-documentation loans via larger required equity tranches and/or higher security yields.

The findings and interpretation of this literature are important for public policy. It is widely believed by policymakers and pundits that securitization itself is problematic, and this has resulted in an international consensus that lenders or securitizers retain risk as part of securitization deals. But the empirical evidence is simply not consistent with such a broad-based conclusion.

W. Scott Frame is a financial economist and senior adviser at the Atlanta Fed. The author thanks Larry Wall for helpful comments. The view expressed here are the author's and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. If you wish to comment on this post, please email atl.nftv.mailbox@atl.frb.org.