Why Does Bank Screening Matter? Private Information and Publicly Traded Securities

Abstract

When bank asset portfolios were first securitized in the 1970s, much attention was paid to making the securitized instruments, such as mortgage-backed securities (MBSs), attractive to what was then a limited number of institutional investors. Following the initial issues, the practice of securitization and demand for securitization instruments both grew strongly throughout the 70s and 80s, and at particularly rapid rates from the 1990s until the crisis of 2007-2008. Since the crisis, demand has fallen off sharply, although at least one new issue of residential mortgage backed securities was reported in April 2012. This paper focuses on a little-recognized but crucial feature of securitization, namely the role of bank information production in determining the quality of securitization instruments. The paper argues both that bank information production is fundamental to determining the quality of securitization instruments, and that the impacts of any changes in information production activity take time for market agents to assess. Moreover, since bank information is produced by assessing individual loan applications, changes in information processing practices can take place rapidly and can also be difficult to detect. The combined result of these features is that information on market-traded securitization instruments can become stale, leading in turn to the possibility of sudden changes in securities valuation as and when information dissemination problems are detected. The paper models the process in order to study the implications in detail. The paper then argues that the skin-in-the game provisions of current Dodd-Frank legislation are too weak to cure information production and transmission problems. On the other hand, a bank-issued put accompanying a securitization issue could go far toward resolving the moral hazard and timing problems affecting the securitization process.