Skin in the Game and Moral Hazard

by Gilles Chemla & Christopher A. Hennessy

What determines equilibrium securitization levels, and should they be regulated? To address these questions we develop a model where originators can exert unobservable effort to increase asset quality, subsequently having private information regarding quality when selling ABS to rational investors. In equilibrium, all originators have low/zero retentions if they are financially constrained and/or prices are sufficiently informative. Asymmetric information lowers effort incentives in all equilibria. Effort is promoted by junior retentions, investor sophistication, and informative prices. Optimal regulation promotes effort while accounting for investor-level externalities. It entails either a menu of junior retentions or a single junior retention with size decreasing in price informativeness. Mandated market opacity is only optimal amongst regulations failing to induce originator effort.

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