Did Securitization Lead to Lax Screening?

A central question surrounding the subprime crisis is whether the securitization process reduced the incentives of financial intermediaries to carefully screen borrowers. In our forthcoming Quarterly Journal of Economics paper Did Securitization Lead to Lax Screening? Evidence From Subprime Loans, we empirically examine this issue using a unique dataset on securitized subprime mortgage loan contracts in the United States.

We exploit a specific rule of thumb in the lending market to generate exogenous variation in the ease of securitization and compare the composition and performance of lenders’ portfolios around the ad-hoc threshold. This rule of thumb is based on the summary measure of borrower credit quality known as the FICO score, where the most prominent approach is to use caution when lending to borrowers with FICO scores below 620. We argue that persistent adherence to this ad-hoc cutoff by investors who purchase securitized pools from non-agencies generates a differential increase in the ease of securitization for loans. That is, loans made to borrowers which fall just above the 620 credit cutoff have a higher unconditional likelihood of being securitized and are therefore more liquid relative to loans below this cutoff.

Using a sample of more than one million home purchase loans during the period 2001-2006, we empirically confirm that the number of loans securitized varies systematically around the 620 FICO cutoff. For loans with a potential for significant soft information – low documentation loans – we find that there are more than twice as many loans securitized above the credit threshold at 620+ vs. below the threshold at 620−. In our tests, we find that while 620+ loans should be of slightly better credit quality than those at 620−, low documentation loans that are originated above the credit threshold tend to default within two years of origination at a rate 10-25% higher than the mean default rate of 5% (which amounts to roughly a 0.5-1% increase in delinquencies). As this result is conditional on observable loan and borrower characteristics, the only remaining difference between the loans around the threshold is the increased ease of securitization. Therefore, the greater default probability of loans above the credit threshold must be due to a reduction in screening by lenders.

Since our results are conditional on securitization, we conduct additional analyses to address selection on the part of borrowers, lenders, or investors as explanations for the differences in the performance of loans around the credit threshold. First, we rule out borrower selection on observables, as the loan terms and borrower characteristics are smooth through the FICO score threshold. Next, selection of loans by investors is mitigated because the decisions of investors (Special Purpose Vehicles, SPVs) are based on the same (smooth through the threshold) loan and borrower variables as in our data.

Our findings suggest that existing securitization practices did adversely affect the screening incentives of lenders.

The full paper is available for download here.