Securitization Means Loss Of Information

Here is a real interesting paper by Keys, et al., (via Yglesias) showing that low documentation mortgages with FICO scores just above the ad hoc securitization cutoff of 620 defaulted at higher rates than those just below. The authors explain:

Comparing characteristics of the loan market above and below the ad-hoc credit threshold, we show that a doubling of securitization volume is on average associated with about a 20% increase in defaults. ... While we cannot take a stance on what the optimal level of screening at each credit score or in the economy ought to be, we conclude from our empirical analysis that there is a causal link between securitization and screening.

...The results underscore the role of illiquidity in preserving banks’ willingness to adequately assess borrowers’ creditworthiness.

...Second, in a market as competitive as the market for mortgage-backed securities, our results on interest rates are puzzling. Lenders’ compensation on either side of the threshold should reflect differences in default rates, and yet we find that the interest rates to borrowers are similar on either side of 620. The differences in defaults despite similar compensation around the threshold suggests that there may have been some efficiency losses.

...It is often asserted that securitization improves the efficiency of credit markets. The underlying assumption behind this assertion is that there is no information loss in transmission even though securitization increases the distance between borrowers and investors. The benefits of securitization are limited by information loss, and in particular the costs we document in the paper. More generally, what types of credit products should be securitized? We conjecture that the answer depends crucially on the information structure: loans with more “hard” information are likely to benefit from securitization as compared to loans that involve “soft” information.