Securitization and Optimal Retention under Moral Hazard

Abstract

Securitization is one of the most important innovations in financial markets. It is a process of converting illiquid loans that cannot be sold readily to third-party investors into liquid securities and selling them to dispersed investors. As a result, securitization improves liquidity in capital markets by allowing originators to remove the issued loans from its balance sheet and use the proceeds for other purposes or even to originate new loans. In spite of all its advantages, securitization is often suspected of being one of the main reasons for the recent financial crisis. One concern that is frequently raised in the literature is that securitization leads to moral hazard in lender screening and monitoring. By selling loans to investors and removing them from their books, banks have a lesser incentive to carefully evaluate and monitor borrowers’ credit quality to ensure that they can repay the loans, because the risk of delinquencies falls on investors rather than lenders. One problem in the literature is that the analysis of securitization is very general and suffers from a lack a specific security design analysis under asymmetric information. We address the moral hazard problem using a principal-agent model where the investor is the principal and the lender is the agent. We show that the optimal contract must contain a retention clause in the presence of moral hazard.