Does Skin‐in‐the‐Game Affect Security Performance?

Abstract

This paper documents that the rise of complex financial innovations like CDOs enabled informed parties in the commercial mortgage backed securitization pipeline to reduce their skin-in-the-game in a way that was not observable to other market participants. This reduction in the amount of first-loss security retention had a significant impact on the probability that more senior tranches ultimately defaulted, after controlling for information available at issue including the market price. We show that this lower performance is entirely driven by the amount of first-loss sold to (affiliated) CDOs within 12 months from the origination of the CMBS deal. Our result is robust to using the differential access of first-loss investors to CDO funding as an instrument to identify plausibly exogenous variations in the retention of first-loss securities.

Keywords: skin-in-the-game, securitization, secondary market, commercial mortgage backed securities

JEL Classification: D82 , G21, G23