Study: Securitization Elicits Risky Lending Practices

Study: Securitization Elicits Risky Lending Practices


The act of securitizing mortgage loans can lead to riskier lending, and ultimately more defaults, according to a study posted by the Federal Reserve Bank of New York.

About 60 percent of outstanding mortgage debt in the United States is traded in the mortgage-backed securities (MBS) market, “making the U.S. secondary mortgage market the largest fixed-income market in the world,” according to the report authored by Fed researchers.

While admitting the MBS market “is an important innovation and has several merits,” the study finds a darker side to the market.

“Our findings suggest that existing securitization practices did adversely affect the screening incentives of lenders,” the Fed researchers stated.

Observing more than 1 million loans from 2001 to 2006, the Fed found MBS portfolios that are likely to be securitized end up defaulting 10 to 25 percent more often than portfolios of similar characteristics that are less likely to be securitized.

“That we find any effect on default behavior in one portfolio compared to another with virtually identical risk profiles, demographic characteristics, and loan terms suggest that the ease of securitization may have a direct impact on incentives elsewhere in the subprime housing market, as well as in other securitized markets,” the Fed researchers stated.

The researchers suggest lenders may lack sufficient “skin in the game.” If they held more of the risk themselves, there would be less variance in portfolio defaults.

Additionally, the study found that while full-documentation loans increased by about 445 percent from 2001 to 2005, low-documentation loans increased by more than twice that—972 percent.

The study concludes that an over-reliance on information such as FICO scores is insufficient as it overlooks “essential elements of strategic behavior on the part of lenders which are likely to be important.”

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