Skin in the Game and Moral Hazard

Formulation of optimal regulation of asset-backed securities (ABS) markets has been hindered by the inability to identify specific market failures as well as the absence of well-defined social welfare objectives. In our paper, Skin in the Game and Moral Hazard, which was recently presented at Harvard University, we develop a tractable framework for analyzing social welfare in both regulated and unregulated ABS markets, accounting for moral hazard at the origination stage, private information at the distribution stage, and asymmetric information across ABS investors. We show originators operating in unregulated markets fail to internalize the costs they impose on investors if they utilize a common ABS structure (e.g. zero retentions) rather than credibly signaling positive information to the market via higher retentions. Further, originator effort incentives are reduced since those developing high value assets must either signal via high retentions or otherwise face underpricing of their securities. Mandated retentions have the potential to raise welfare by increasing originator effort incentives in an efficient way, accounting for investor-level spillovers.

The first important policy implication to emerge from the model is that regulators must choose between a “one-size scheme” under which all originators are forced to hold the same retention size (e.g. 5%) or a “menu scheme” under which originators must choose amongst multiple retention sizes (e.g. 4% or 8%). Both schemes can restore effort incentives. However, the menu scheme carries the added social benefit of allowing originators to signal positive information to investors via the choice of a larger retention. Signaling promotes efficient sharing of risks by mitigating the adverse selection problem confronting uninformed ABS investors. The weakness of the menu scheme is that it generally results in higher average retentions, resulting in lower originator fundraising.

Second, in either type of scheme, originators should be required to hold the most junior tranche. Retention of a junior tranche provides originators with the maximum funding possible while still providing effort incentives. Further, under the menu scheme, retaining a large junior tranche represents the most cost-effective signaling device. Mandating originators hold an equal stake in each ABS tranche is inefficient from an incentive and signaling perspective.

Third, price discipline is a substitute for retentions in providing effort incentives.  Consequently, in the proposed one-size scheme the mandated retention is smaller if the regulator expects informed trading to drive prices closer to fundamentals. For example, securitized assets with high documentation levels should carry smaller retention requirements than assets with low levels of documentation. Moreover, we show the one-size scheme dominates the menu scheme only in those markets with high levels of informed trading. Thus, formulation of optimal regulation requires taking a view on the degree to which informed trading will drive prices closer to fundamentals. Regulations calling for a 5% retention standard across vastly different ABS markets appear inappropriate.

Fourth, we show that commonplace criticism of tranching (“slicing-and-dicing”) is misguided. Tranching has a number of valuable functions. It allows uninformed hedging investors to achieve their desired risk exposure. In turn, the presence of uninformed hedging investors increases the return to informed speculation. In turn, informed speculation drives prices closer to fundamentals and increases the return to an originator for developing a high quality asset.

Finally, we show mandated opacity maximizes social welfare if there is no moral hazard problem at the origination stage. This is because opacity preserves symmetric ignorance across investors which promotes efficient risk sharing. However, once one accounts for moral hazard opacity is highly problematic since it prevents informed trading and concomitant price discipline. That is, if a key goal of ABS regulation is to increase the incentive of originators to screen borrowers, as it appears to be, policy should aim to decrease the cost to investors of acquiring and trading on information about underlying asset values. From this perspective, the enhanced disclosure requirements of Regulation AB should be applauded. An important next step will be to increase the liquidity and transparency of ABS trading mechanisms.

The full paper is available for download here.