Does SkinninntheeGame Affect Security Performance? Evidence from the Conduit CMBS Market

Abstract

We document that the amount of first-loss security retention in the conduit CMBS market has a significant impact on the probability that more senior tranches ultimately default. In particular, we demonstrate that an increase in the amount of first loss security retention is correlated with better security performance, after controlling for information available at issue. We then identify plausibly exogenous variation in the amount of first-loss security retention, relying on the greater ability of larger first loss investors to sell these positions into CRE CDOs given the need for large pools of collateral. Using this variation as an instrument, we measure a causal link between retention and performance. Further, we demonstrate that the risk associated with this agency problem was not priced at origination, as the interest rate on senior securities is not correlated with the amount of retention. Together, the evidence is consistent with the hypothesis that first-loss security retention is not supported by competitive market equilibrium and suggests that regulation of retention could improve outcomes.