Boston Fed Finds Mortgage Securitization Did Not Cause Lax Origination Screening Prior To Financial Crisis: Fannie And Freddie Able To Control Lenders’ Screening Rules: No Moral Hazard: 5% Dodd-Frank Mortgage Securitization Retention Rule Unneeded

From The Federal Reserve Bank of Boston, "Securitization and Moral Hazard: Evidence from Credit Score Cutoff Rules" by Ryan Bubb and Alex Kaufman, Public Policy Discussion Paper No. 11-6:

It has now become conventional wisdom that securitization contributed to the sharp rise in mortgage defaults that precipitated the recent financial crisis. The logic of the moral hazard problem posed by securitization is straightforward: lenders that sell loans they originate to dispersed investors may bear less of the cost when loans default, and hence they may have less incentive to screen borrowers. The belief that this moral hazard problem played an important role in the financial crisis has influenced regulatory reform, with the 2010 Dodd-Frank Act adopting a requirement that securitizers and/or originators retain a 5 percent interest in mortgages they securitize to better align their incentives.

However, there are reasons to think that securitization may not have had a large moral hazard effect on lender screening. Mortgage securitization was developed over decades, and as early as 1993 the overall securitization rate was nearly as high as in the period leading up to the financial crisis.

Lenders and securitizers both had strong incentives to devise ways to avoid the moral hazard problem posed by securitization, and a range of practices were indeed developed to mitigate it (Gorton, 2009). These include contractual provisions such as representations and warranties by lenders and clauses that require lenders to buy back loans that default soon after sale, monitoring strategies like the extensive underwriting guidelines and audits used by some large loan purchasers, and software systems that automate parts of the mortgage underwriting process. Hence, the extent to which securitization actually reduced lenders’ screening is an empirical question.***Our findings provide evidence that securitizers were to some extent able to mitigate the incentive problems posed by securitization. When Fannie Mae and Freddie Mac, the two largest mortgage purchasers, determined that using credit score cutoff rules to determine how carefully to scrutinize loan applications could improve mortgage underwriting, they included credit score cutoff rules in their underwriting guidelines. The ubiquity of the 620 and 660 FICO credit score cutoff rules in the 3mortgage markets is a testament to the ability of Fannie and Freddie to enforce their underwriting guidelines through software, contractual provisions, and monitoring. Interpreted in light of our findings and analysis, the discontinuities in default at certain credit score thresholds do not provide evidence for the hypothesis that securitization led to lax screening. Rather, they provide evidence for the opposing hypothesis: large securitizers like Fannie and Freddie were to some extent able to regulate lenders’ screening behavior. [Emphasis Added].

Read the complete research paper here.