Did Securitization Lead to Riskier Corporate Lending?
João Santos
February 04, 2013



There’s ample evidence that securitization led mortgage lenders to take more risk, thereby contributing to a large increase in mortgage delinquencies during the financial crisis. In this post, I discuss evidence from a recent research study I undertook with Vitaly Bord suggesting that securitization also led to riskier corporate lending. We show that during the boom years of securitization, corporate loans that banks securitized at loan origination underperformed similar, unsecuritized loans originated by the same banks. Additionally, we report evidence suggesting that the performance gap reflects looser underwriting standards applied by banks to loans they securitize.

Historically, banks kept on their books the loans they originated. However, over time they increasingly replaced this originate-to-hold model with the originate-to-distribute model, by syndicating the loans they originated or by selling them in the secondary loan market. The growth of securitization provided banks with yet another opportunity to expand the originate-to-distribute model of lending. The securitization of corporate loans grew spectacularly in the years leading up to the financial crisis. Prior to 2003, the annual volume of new collateralized loan obligations (CLOs) issued in the United States rarely surpassed $20 billion. Since then, this activity grew rapidly, eclipsing $180 billion in 2007.

Corporate loan securitization appealed to banks because it gave them an opportunity to sell loans off their balance sheets—particularly riskier loans, which have been traditionally more difficult to syndicate. By securitizing loans, banks could lower the risk on their balance sheets and free up capital for other business while continuing to earn origination fees. As with the securitization of other securities, the securitization of corporate loans, however, may lead to looser underwriting standards. For example, if banks anticipate that they won’t retain in their balance sheets the loans they originate, their incentives to screen loan applicants at origination will be reduced. Further, once a bank securitizes a loan, its incentives to monitor the borrower during the life of the loan will also be reduced.

To investigate whether securitization affected the riskiness of banks’ corporate lending, my paper with Bord compared the performance of corporate loans originated between 2004 and 2008 and securitized at the time of loan origination with other loans that banks originated but didn’t securitize. We found that the loans banks securitize are more than twice as likely to default or become nonaccrual in the three years after origination. While only 6 percent of the syndicated loans that banks don’t securitize default or become nonaccrual in those three years, 13 percent of the loans they do securitize wind up in default or nonaccrual. This difference in performance persists, even when we compared loans originated by the same bank and even when we compared loans that are “similar” and we controlled for loan- and borrower-specific variables that proxy for loan risk.

Our results suggest that banks use laxer standards to underwrite the loans they sell to CLOs. For example, we find that banks put less weight on the “hard” information on borrower risk when they set spreads on the loans sold to CLOs than on the loans they don’t securitize. We also find that banks retain less “skin in the game” when it comes to securitized loans, suggesting that they have less incentive to monitor these loans after origination. While on average banks retain 26 percent of each syndicated loan they originate but don’t securitize, they retain only 9 percent of each loan they do securitize. This difference in underwriting standards may help explain why banks’ securitized loans underperform unsecuritized loans.

Finally, we find evidence that all loan investors, including banks, expect that securitized loans will perform worse. Banks appear to do so because they charge significantly higher interest rates on these loans than on the loans they don’t securitize. Institutional investors, who together with the originating bank and CLOs acquire the loans that banks securitize, follow the loan originator and choose to acquire a smaller stake in securitized loans.

Our evidence that securitization led to riskier corporate lending is in line with similar findings unveiled by studies of the effects of securitization on mortgage lending. Taken together, these studies confirm an important downside of securitization.

The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.

João Santos is a vice president in the Research and Statistics Group of the Federal Reserve Bank of New York.

Category: Credit, Derivatives, Think Tank

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

4 Responses to “Did Securitization Lead to Riskier Corporate Lending?”

  1. beezle says:

    So… clearly GNMA/RMBS which began in … 1968! … were responsible for what happened in 2003-2008? I suppose you can, like anything else, make statistics show whatever you want but that conclusion is bunk.

    The real problem is that the Fed and Treasury bailed out and continue to bail out the banks and brokers. Failure is a good way to increase the risk premium.

  2. phoneranger says:

    There is (conceptually) nothing wrong with securitizing piles of toxic waste and selling it to institutions at a risk-appropriate rate. But when yield-greedy institutions outsource their risk analysis to ratings agencies whose priorities don’t necessarily include unbiased “research”, you’re going to have a problem.

  3. Fred C Dobbs says:

    The banks have incentives to sell loans the originate. By selling loans, they are able to make more loans and generate more loan fees. In fact, if they turnover their entire new loan portfolio every 30 days, they can make 12 times in loan fees than they will if they make and hold a loan for a year. This is a good incentive for society, for surplus capital from one area is sent to a capital deficient area when the buyer pays the seller for the loans. There is another incentive. When the loan is made when the market is at one rate, and sells it when the market is at a lower rate, the seller gets to book receipt of a “profit,” called ‘gain on sale.’ Lastly, banks have an incentive to retain ‘servicing,’ i.e. monitor the loan for the benefit of the buyer, for a fee. For servicing, the servicer makes more money the more the loan requires servicing. All of these incentives combine to encourage loans to be made as fast as they can be made, and sold as fast as they can be sold. This emphasis on speed formerly ran into the delay that use to occur when the banks went to the time-honored trouble of verifying the loan applicant’s financial statement. Formerly, banks checked whether the applicant was employed, where he said he was and was being paid what he said he was. The banks checked whether the applicant actually had an account in a bank like he said he did, with the amount on deposit he said he had. But checking the loan applicant’s honesty slowed down the whole process, so they did away with the verification phase of the loan making process. “no doc” and ‘nothing down’ loans eliminated the need to check. It also opened up a new market in the economy. It made borrowers of people who had previously been unable to borrow because they were not creditworthy. This vast, seemingly unlimited supply of deadbeats that banks lent other people’s money to and sell their worthless promises through Wall Street is the result. Incentives to book more profits faster was the game.

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