Incentives in the Market for Mortgage-Backed Securities

We study the nonprime (subprime and alt-A) business model of making and then securitizing risky home loans involving little or no borrower equity to marginal borrowers. In our model, originators make nonprime loans, bankers investigate loan quality (due diligence) and then securitize a fraction of the loans to meet money managers’ demand for mortgage-backed securities (MBSs), default risk is increasing in supply, money managers compete in a tournament for investor funds, and investors rely on money managers’ past performance relative to a benchmark as a signal of their skill. We show that bankers may conduct less due diligence as loan volume (and risk) increases, some money managers will buy overpriced MBSs, money managers may conduct less diligence as risk increases and have incentives to understate risk to investors, an asset price bubble may form, especially if investors underestimate risk or money manager diligence or money managers underestimate banker diligence, and the bubble will tend to grow as long as economic times remain good. In equilibrium, bankers rationally buy and securitize large amounts of high downside risk MBS, with little or no investigation, and rational money managers purchase them. Legal due diligence requirements for bankers and money managers can reduce the size and probability of a possible bubble.