Working Paper: CEPR ID: DP7483
Authors: Ingo Fender; Janet Mitchell
Abstract: This paper examines the power of different contractual mechanisms to influence an originator's choice of costly effort to screen borrowers when the originator plans to securitise its loans. The analysis focuses on three potential mechanisms: the originator holds a "vertical slice", or share of the portfolio; the originator holds the equity tranche of a structured finance transaction; the originator holds the mezzanine tranche, rather than the equity tranche. These mechanisms will result in differing levels of screening, and the differences arise from varying sensitivities to a systematic risk factor. Equity tranche retention is not always the most effective mechanism, and the equity tranche can be dominated by either a vertical slice or a mezzanine tranche if the probability of a downturn is likely and if the equity tranche is likely to be depleted in a downturn. If the choice of how much and what form to retain is left up to the originator, the retention mechanism may lead to low screening effort, suggesting a potential rationale for government intervention.
Keywords: borrower screening; retention requirements; securitisation; tranching
JEL Codes: D82; D86; G21; G28
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Equity tranche (G12) | Lower screening effort (C55) |
| Probability of downturn (E32) | Lower screening effort when holding equity tranche (G11) |
| Mezzanine tranche (G19) | Higher screening effort (J78) |
| Vertical slice (Y60) | Higher screening effort (J78) |
| Retention mechanism choice (D25) | Screening efforts (I18) |
| Regulatory intervention (G18) | Improved screening outcomes (I14) |