Securitization and Moral Hazard: Evidence from Credit Score Cutoff Rules

Abstract:     
Did mortgage securitization lead to moral hazard in underwriting? A growing body of research addressing this question exploits credit score cutoff rules. If securitizers use cutoff rules to determine which loans to buy, the resulting discontinuities in the ease of securitization can potentially be used as a natural experiment. We reexamine the evidence from credit score cutoff rules and find it has been misinterpreted. The origin of these cutoff rules can be traced to underwriting guidelines for lenders, not for securitizers, that were established by Fannie Mae and Freddie Mac in the mid-1990s and have since become de facto industry standards. Because lenders independently employ cutoff rules in underwriting, one cannot use these same cutoff rules to learn about the effect of securitization on underwriting. Using loan-level data we find widespread use of such cutoffs by lenders but little evidence of their use by securitizers. Rather than implying that mortgage securitization led to moral hazard, credit score cutoff rules provide evidence for the opposing hypothesis: large securitizers were to an extent able to regulate lenders' underwriting practices.

Number of Pages in PDF File: 43

Keywords: securitization, moral hazard, mortgages, subprime crisis, financial crisis

JEL Classification: D82, G01, G18, G21, G24, G28, N22

working papers series