In the aftermath of the subprime mortgage crisis, many people are wary of securitization—the bundling and selling of loans to investors—assuming that the problems associated with securitized residential mortgages outweigh the benefits of securitization and that the problems with the subprime securities are present in other securitized asset classes.
Despite its reputation, securitization provides important benefits. My colleague Rossen Valkanov of the University of California, San Diego and I studied securitization in the commercial mortgage market to determine whether the problems associated with subprime mortgage securitization translate to other markets and test for evidence of the benefits of securitization in a unique setting.
Securitization frees up capital for development and reduces lenders’ exposure to idiosyncratic risk. For example, a single loan of $1 billion is riskier than $1 billion spread across a pool of loans. Consistent with this reasoning, we found that large commercial mortgages are far more likely to be securitized than smaller ones.
Critics of securitization argue that securitized loans are of lower quality after controlling for observables than non-securitized loans. The idea is that the loan originator doesn’t care about the quality because somebody else will end up with it.
We didn’t find this to be the case with commercial loans. Our research suggests that mechanisms in the commercial market prevent bad bundles. One concern people have about the residential mortgage market is that mortgage originators acquire information about the quality of loans through the origination process and then use that information to pawn off the bad loans to investors. However, loan originators in the commercial market know up front which loans will be securitized, so there isn’t any information asymmetry.
Thus far, there has not been any substantial move toward increased regulation of the commercial mortgage market, which is good. Although the SEC has adopted new rules on risk retention for securitization, those rules left largely intact the existing risk retention arrangements the securitized commercial mortgage market uses. If regulation of commercial markets were to become onerous, it could dry up much of the capital in that market. Commercial mortgages are critical to constructing office buildings, apartments, industrial properties, and retail spaces. If this market were constrained, it could have a significant negative impact on communities.
So even after the subprime mortgage crisis, could mortgage-backed securities be a good thing? Our research finds that in the commercial real estate market, the answer is yes.
For more on this topic, see our paper “Comparing Securitized and Balance Sheet Loans: Size Matter” in Management Science.
Andra Ghent is Lorin and Marjorie Tiefenthaler Fund, and associate professor of real estate & urban land economics at the Wisconsin School of Business.
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