Originate-to-Distribute and Screening Incentives

Abstract

Conventional wisdom holds that lax screening during the subprime boom was the inevitable result of the originate-to-distribute (OTD) business model under which originators retain zero interest in complex tranched securities (CDOs). This has led to calls for originators to maintain more skin-in-the-game (SITG) and curbs on CDOs. We examine these claims in a fully rational model where originators first choose screening effort and then use private information regarding value in deciding between signaling via retentions versus pooling at OTD cum optimally structured CDOs. Contrary to conventional wisdom, we show screening incentives can actually be stronger under OTD, but only if two conditions are met: orginators attach high value to immediate funding and informed trading drives prices sufficiently close to fundamentals. We argue that lax lending standards during the subprime boom can be understood as arising endogenously from insufficient informed trading in CDO markets. Limits on tranched CDOs are shown to be misguided. Tranching creates Arrow securities demanded by hedgers who serve as trading partners for informed speculators who drive prices closer to fundamentals. We also show that screening and no screening by originators can be self-fulfilling prophecies as changes in the probability distribution of CDO quality shift incentives for information acquisition. Finally, we show that bans on shorting alter speculator trading capital needs, decreasing (increasing) the informational efficiency of prices if the unconditional expected quality is high (low).