Equity Allocation and Risk-Taking in the Intermediation Chain

Abstract

We build an equilibrium model of the capital structure and risk-taking in the originate-to-distribute intermediation chain in presence of absolute demand for safety by some investors and limited endowment by equity investors. Loan originators may expand investment by raising funds from intermediaries that diversify idiosyncratic risks to create safe securitized assets. Equity funding allows originators to improve their risk-taking incentives and intermediaries to absorb losses from their exposure to aggregate risk. The competitive allocation of equity renders the equilibrium Pareto constrained efficient. Consistent with the saving glut narrative of the expansion of securitization in the run-up to the crisis, an increase in the demand for safety leads to increases in the overall equity invested in intermediaries, the relative size of the intermediary sector and risk-taking at origination. Government policies that include fiscally neutral guarantees to the issuance of securitized assets lead to Pareto improvements in the economy, have ambiguous risk-taking effects at origination, and are preferable to guarantees to originators because of intermediaries' higher exposure to aggregate risk.

Keywords: capital structure, risk-taking, originate-to-distribute, diversification, spreads, saving glut

JEL Classification: G01, G20, G28