How Smart are Investors after the Subprime Mortgage Crisis? Evidence from the Securitization Market

Abstract

In this paper, we examine whether investors of securitizations anticipate screening and monitoring incentives of originators. The theoretical literature suggests that retention of the first loss tranche (equity retention) leads to a maximization of screening and monitoring efforts. Thus, equity retention should result in a reduction of credit spreads if investors anticipate these incentives.Using a unique data set of securitizations, we find for information sensitive tranches, for which screening and monitoring incentives have the greatest impact, that investors require an additional risk premium of more than 60 basis points if originators do not retain a material share of securitizations. Furthermore, an equally weighted retention of each issued tranche (vertical slice retention) also leads to a significantly higher risk premium compared to equity retention. For information insensitive tranches, though, we argue that losses are only likely in downturn scenarios, where the first loss tranche is expected to default completely. Thus, from the perspective of AAA investors, equity retention does not lead to a harmonization of interests and might therefore not be the favored security design. Instead, vertical slice retention should lead to higher monitoring incentives and consequently to lower credit spreads. Consistent to this argument, we find that vertical slice retention causes a significantly lower risk premium than equity retention. However, due to the information insensitive nature of AAA tranches, the spread difference is materially lower with about 30 basis points. Overall, we find evidence that investors indeed consider asymmetric information in pricing securitizations. These results significantly contribute to the understanding of how asymmetric information influences credit spreads.