Securitization, Ratings, and Credit Supply

Abstract

We develop a framework to explore the interaction between loan origination and securitization. In the model, banks privately screen and originate loans and then issue securities that are backed by loan cash flows. Issued securities are rated and sold to investors. We show that the availability of credit ratings (or other public information) increases the allocative efficiency of cash flows by reducing costly retention, but reduces lending standards and can lead to an oversupply of credit. These findings are in contrast to regulators’ view of credit ratings as a disciplining device. Moreover, improved screening does not solve the problem; as banks’ screening technology becomes more precise, their lending standards collapse and some (though not all) bad loans are deliberately originated. We use the model to explore several commonly proposed policies and provide conditions under which they increase efficiency. Finally, we consider extensions to allow for ratings shopping and manipulation.