Competition, Innovation and Crises: Evidence from 20 Million Securitized Loans

This paper asks: why did innovation in securitized mortgages spike before the 2007-09 crisis? We propose that this innovation was driven by increased competition among sponsors who securitized and sold mortgages i.e., these sponsors demanded more innovative mortgages from originators who complied. We use a regulatory change in 2000 that generated plausibly exogenous variation in local sponsor competition, to empirically identify the effect of sponsor competition on loan innovation. By comparing cohorts of loans securitized during the same time, we show that sponsor-induced innovation led to riskier mortgages being packaged into Prime deals during the pre-crisis boom period. This evidence of riskier collateral backing lower-yielding MBS is consistent with the obfuscation motives of sponsors.