The Relation between Bank Credit-Risk Management Procedures and Originate-to-Distribute Mortgage Quality During the Financial Crisis

Abstract

We examine the relation between bank risk-assessment procedures and sales of mortgages before and after the first quarter of 2007. Research (Purnanandam [2010]) suggests that banks employing an originate-to-distribute (OTD) strategy devoted little effort to screening thereby diminishing their ability to sell loans during the crisis. We use 10-K disclosures of credit-risk assessment procedures to measure the extent of a bank’s internal screening and risk-management procedures. We find banks with higher scores (i.e., stronger risk management) were better able to sell mortgages during the financial crisis and had fewer non-performing mortgage loans than banks with lower scores. In addition, we find higher scores attenuate the positive association between a bank’s use of more mechanical screening techniques and its involvement in the OTD market documented by Purnanandam [2010]. Thus, enhanced credit-risk management procedures seem to mitigate incentives to substitute mechanical screening models for the collection of costly information when banks more zealously employ an OTD strategy. Taken together, these results imply that mortgage purchasers were aware of cross-sectional differences and suggest that mechanisms exist for banks to credibly distinguish the quality of their loans despite incentives problems associated with the OTD business model.

Keywords: Originate-to-distribute; risk assessment procedures; financial crisis

JEL Classification: G11; G12; G13; G14; G21; G32