Originate-to-Distribute Model and the Sub-Prime Mortgage Crisis

Abstract:     
An originate-to-distribute (OTD) model of lending, where the originator of a loan sells it to various third parties, has become a popular vehicle for credit and liquidity risk-management in recent years. This method of lending was very popular in the mortgage-loans market until a disruption in this market began in the middle of 2007. We show that the extent of a commercial bank's participation in the OTD mortgage market prior to the mid-2007 disruption positively predicts its mortgage chargeoffs in the post-disruption period. These losses are more pronounced among banks that are unable to sell their OTD mortgage loans to third parties in the post-disruption period. We also provide some evidence in support of higher foreclosure rates for OTD mortgages. These findings lend support to the view that the transfer of credit-risk through the OTD market resulted in the origination of inferior quality loans by the banks. We explore the effect of bank's capital and liability structure on this behavior and show that these effects are larger for capital constrained banks and banks that rely less on demand deposits. Overall, we provide evidence that lack of screening incentives coupled with leverage induced risk-taking behavior significantly contributed to the current sub-prime mortgage crisis. The fragility of bank's capital structure acted as a moderating device.

Keywords: Sub-prime crisis, originate-to-distribute, screening, bank loans, risk-management

JEL Classifications: G10, G11, G12

Working Paper Series