Tug-of-War: Incentive Alignment in Securitization and Loan Performance

We investigate the incentive alignment of mortgage deal sponsors and underwriters on securitized loan performance. We argue that securitized loans with affiliated sponsor-underwriter are associated with poor performance due to underwriters' stronger incentive to reduce the loss exposure of their affiliated deal sponsors. Using a comprehensive residential mortgage dataset with more than 7.4 million loans originated between 2003 and 2007, we find strong empirical evidence supporting our predictions. Our results are robust to a battery of sensitivity tests including controlling for adverse selection. Finally, we find no evidence that the detrimental effect on loan performance from the sponsor-underwriter affiliation is reflected in the mortgage deal pricing or their credit enhancement. The evidence in our paper highlights the importance to understand the incentive alignments among different players in the securitization process.