Demand for Safety, Risky Loans: A Model of Securitization

Abstract

We build a competitive equilibrium model of securitization in presence of demand for safety by debt investors. Securitization vehicles create safe assets by pooling idiosyncratic risks from loan originators. Equity is endogenously allocated to provide skin-in-the-game in originators and loss-absorption against aggregate risk in vehicles. Credit expansions driven by increases in safety demand lead to securitization booms and riskier loans. They also induce reallocations of equity towards junior tranches of securitized assets that may increase loan risk and reduce output relative to standard credit supply expansions. We find novel predictions on loan and equity risk premia consistent with empirical evidence.

Keywords: Diversification, moral hazard, Originate-to-distribute, Safety demand, Securitization

JEL Classification: G01, G20, G28