does regulatory capital arbitrage, reputation, or...

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Does Regulatory Capital Arbitrage, Reputation, or Asymmetric Information Drive Securitization? BRENT W. AMBROSE* University of Kentucky MICHAEL LACOUR-LITTLE** California State University, Fullerton ANTHONY B. SANDERS The Ohio State University Abstract Banks can choose to keep loans on balance sheet as private debt or transform them into public debt via asset securitization. Securitization transfers credit and interest rate risk, increases liquidity, augments fee income, and improves capital ratios. Yet many lenders still retain a portion of their loans in portfolio. Do lenders exploit asymmetric information to sell riskier loans into the public markets or retain riskier loans in portfolio? If riskier loans are indeed retained in portfolio, is this motivated by regulatory capital incentives (regulatory capital arbitrage), or a concern for reputation? We examine these questions empirically and find that securitized mortgage loans have experienced lower ex-post defaults than those retained in portfolio, providing evidence consistent with either the capital arbitrage or reputation explanation for securitization. Key words: Banks, debt, securitization, regulatory capital. Securitization is one of the major financial innovations to have occurred over recent decades (Greenspan, 1998). In securitization, heterogeneous and illiquid individual loans are combined into relatively homogeneous pools and transformed into highly liquid bonds traded in dealer markets and generically referred to as asset-backed securities. Such assets now permeate fixed income portfolios at both the institutional and individual investor level. While the largest and most well known example of securitization is the residential mortgage market, over the past decade securitization has spread rapidly into home equity loan markets, commercial loan markets, credit card receivables, auto loans, small-business loans, corporate loans, and other loan types. Although better developed in the U.S. than in most other industrialized nations, securitization is expanding into foreign markets as well [see, for example, Taylor (1996) for a summary of securitization activity in European markets]. * Please address correspondence to Brent W. Ambrose, University of Kentucky, Gatton College of Business and Economics, Lexington, KY 40506-0053. E-mail: [email protected]. ** Research completed while affiliated with Washington University in St. Louis. Journal of Financial Services Research, 28:1/ 2/3 113–133, 2005 # 2005 Springer Science + Business Media, Inc. Manufactured in The Netherlands.

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Does Regulatory Capital Arbitrage, Reputation,or Asymmetric Information Drive Securitization?

BRENT W. AMBROSE*

University of Kentucky

MICHAEL LACOUR-LITTLE**

California State University, Fullerton

ANTHONY B. SANDERS

The Ohio State University

Abstract

Banks can choose to keep loans on balance sheet as private debt or transform them into public debt via asset

securitization. Securitization transfers credit and interest rate risk, increases liquidity, augments fee income, and

improves capital ratios. Yet many lenders still retain a portion of their loans in portfolio. Do lenders exploit

asymmetric information to sell riskier loans into the public markets or retain riskier loans in portfolio? If riskier

loans are indeed retained in portfolio, is this motivated by regulatory capital incentives (regulatory capital

arbitrage), or a concern for reputation? We examine these questions empirically and find that securitized

mortgage loans have experienced lower ex-post defaults than those retained in portfolio, providing evidence

consistent with either the capital arbitrage or reputation explanation for securitization.

Key words: Banks, debt, securitization, regulatory capital.

Securitization is one of the major financial innovations to have occurred over recent

decades (Greenspan, 1998). In securitization, heterogeneous and illiquid individual loans

are combined into relatively homogeneous pools and transformed into highly liquid

bonds traded in dealer markets and generically referred to as asset-backed securities.

Such assets now permeate fixed income portfolios at both the institutional and individual

investor level. While the largest and most well known example of securitization is the

residential mortgage market, over the past decade securitization has spread rapidly into

home equity loan markets, commercial loan markets, credit card receivables, auto loans,

small-business loans, corporate loans, and other loan types. Although better developed in

the U.S. than in most other industrialized nations, securitization is expanding into foreign

markets as well [see, for example, Taylor (1996) for a summary of securitization activity

in European markets].

* Please address correspondence to Brent W. Ambrose, University of Kentucky, Gatton College of

Business and Economics, Lexington, KY 40506-0053. E-mail: [email protected].

** Research completed while affiliated with Washington University in St. Louis.

Journal of Financial Services Research, 28:1/2/3 113–133, 2005# 2005 Springer Science + Business Media, Inc. Manufactured in The Netherlands.

Asset securitization creates value by increasing liquidity, reducing or reallocating

credit or interest rate risk, improving leverage ratios, and allowing recognition of

accounting gains. Moreover, many of these securities provide the raw material for

synthetic securities traded in derivatives markets, expanding the market for the underlying

asset. In the process, financial re-engineering can create entirely new cash flow patterns

tailored to meet diverse clientele needs. Investors are attracted to the spread over

government security rates on asset-backed securities and trade off liquidity, interest rate,

call, and credit risk for the higher yields available in the asset-backed market.1

According to the Bond Market Association, as of the end of the first quarter of 2004,

the asset-backed market comprised just under one-third of the total $22.5 trillion bond

market. Within this category, mortgage-related assets were the largest component,

comprising approximately $5.3 trillion, with other asset-backed securities totaling $1.7

trillion. The combined category, and even the mortgage-related category alone, exceeds

the size of the Treasury market ($3.7 trillion) or the corporate bond market ($4.5 trillion).

Yet banks and thrifts still hold approximately $2.6 trillion in mortgage loans on their

balance sheets, representing about one-third of all outstanding mortgage debt (including

both public and private forms). How and why has this pattern developed?

Securitization first appeared in the residential mortgage market in the early 1980s and

received a major boost when the Tax Reform Act of 1986 incorporated legislation

authorizing real estate mortgage investment conduits (REMICs), a tax- and accounting-

favored structure under which assets to be securitized are transferred to a bankruptcy-

remote trust, thereby insulating the performance of securities issued from the financial

position of the issuer.2 As a result, by 1993, private issuers accounted for 15 percent of

total mortgage-backed securities volume (Korrell, 1996).

Furthermore, in the U.S. mortgage market, a well-developed institutional structure

exists to facilitate securitization for the majority of loans. Freddie Mac and Fannie Mae

(together the government-sponsored enterprises, the agencies, or the GSEs) were

chartered by Congress specifically to create a secondary market in mortgage debt to

ensure the continued availability of funds for housing finance.3 Both agencies purchase

1 See Bernardo and Cornell (1997) for an empirical analysis of Wall Street pricing of derivatives backed by

mortgage-backed securities.

3 Initially, Fannie Mae created a market for government-insured mortgage loans and Freddie Mac created an

analogous market for conventional loans, at that time originated mainly by savings institutions.

2 Ranieri (1996) traces the origins of securitization in the United States to the late 1970s when the word itself

first appeared in the Wall Street Journal. Kendall (1996) discusses the institutional requirements for

securitization to develop. Furthermore, Thomas (2001) notes that securitization is a natural response to

information asymmetries arising from project financing as well as comparative advantages in loan

servicing. For example, the signaling model developed by Greenbaum and Thakor (1987) suggests that

securitization allows financing of projects having significant information asymmetry between borrower and

lender, while the risk allocation models of Benveniste and Berger (1987) and James (1988) indicate that

securitization overcomes potential wealth transfers from shareholders to depositors, allowing lenders to

fund projects that otherwise would not be funded. As a result, securitization is a natural response to the

underinvestment problem proposed by Myers (1977), which suggests that firms may forgo profitable

investment opportunities if such investments result in possible wealth transfers from equity holders to debt

holders.

114 AMBROSE ET AL.

loans under either cash or swap programs (Fabozzi and Dunlevy, 2001). In the swap

program, large pools of loans are swapped with a single lender in return for a mortgage-

backed security collateralized by the same pool of loans. Interest on the pool of loans

covers servicing costs, typically paid to the originator, a guarantee fee paid to the agency,

and the balance of the available interest payments are available for the coupon on the

security. Under the cash program, the agencies purchase smaller pools of loans and

combine them into larger multi-lender pools and issue securities backed by them. In

either case, the originator can realize all loan fees collected in excess of costs as current

period profits and can continue to earn ongoing fees for loan servicing with limited

balance-sheet exposure and without any credit risk.4

After authorization of REMICs in 1986, a market in non-agency mortgage-backed

securities also developed. Non-conforming loans may be securitized in these private-

label issues, though alternative credit enhancement structures are required, since

guarantees are not available from the agencies. Non-conforming loans are either too

large to meet conforming size limits ( jumbos) or do not meet agency underwriting

guidelines (Alt-A or subprime). Typically, multi-class securities are issued with sub-

ordinate tranches bearing most of the credit risk. In this case, credit risk may not be

completely transferred, since issuers sometimes retain subordinate pieces of the security.

Collateralized mortgage obligations (CMOs) further reallocate risk by prioritizing receipt

of amortization, both scheduled and unscheduled prepayments, to allow expected matu-

rities to be more precisely defined.5

Regardless of the mode or outlet, securitization increases liquidity for the originator.

Under the agency swap program, the originator receives a liquid asset in the form of a

mortgage-backed security; under the cash program, the lender has cash proceeds to

reinvest, either in additional mortgage lending or in alternative liquid instruments, such

as Treasury securities. Under a non-agency REMIC structure, the lender will receive cash

proceeds net of transaction costs from sale of the multi-class securities issued.

For banks, an additional benefit is that securitization reduces the level of regulatory

capital required. Under current Basel capital rules, residential mortgage loans that have

been prudently underwritten generally require a 50 percent risk weighting, i.e., 2 percent

capital (50 percent times the 4 percent standard Tier 1 capital requirement), whereas

agency securities require only a 20 percent risk weighting, i.e., 0.8 percent capital. For

details on the bank capital rules and current proposals to make requirements better

conform to actual risk levels, see Calem and LaCour-Little (2004). They argue that, for

most mortgage loans, existing regulatory capital levels are too high, creating an incentive to

securitize the least risky loans. Furthermore, Passmore et al. (2002) demonstrate that the

incentive to securitize loans declines as regulatory capital requirements increase. Con-

4 This assumes the originator’s credit quality is sufficient to sell loans on a non-recourse basis, which is not

always the case. If lenders produce poor quality loans, the GSEs may condition future purchases on

recourse.

5 The CMO structure channels mortgage principal payments (both amortization and prepayments) to a series

of bonds. As of year-end 2002, almost $1.0 trillion in agency CMOs were outstanding. (Source: The Bond

Market Association).

SECURITIZATION 115

sistent with some of the literature, we refer to the decision to hold an asset in securitized

form to minimize regulatory capital requirements as regulatory capital arbitrage.

In addition to regulatory capital rules favoring securitization, the presence of

information asymmetries may also encourage securitization. If we assume that the

lender is better informed about the borrower’s credit quality than are the purchasers of

the securitized debt, then the purchasers of securitized debt may set credit standards that

are higher than those of the lender in order to protect themselves against the possible

Blemons market^ outcome suggested by Akerlof (1970). For example, DeMarzo and

Duffie (1999) using a liquidity-based model of securitization show that if asymmetric

information results in the lender’s facing a downward sloping demand curve for its

mortgage-backed security, then an optimal strategy is to retain a portion of the loans

in portfolio. Their model implies that if the issuer does not wish to retain any portion

of the mortgage-backed security, then she should sell only those loans having the lowest

degree of asymmetric information into the pool and retain those loans with a high degree

of asymmetric information. Hence, the lender may retain loans that are higher risk

(and have higher rate spreads) than those sold to the secondary loan market.6 As a result,

we would predict that retained loans have a higher incidence of default than those sold to

the secondary market. Alternatively, DeMarzo (2005) develops a model in which

informed financial intermediaries with superior information about asset valuation buy

pools of loans and enhance their returns on capital by creating derivative securities by

Btranching^ those pools based on specific risk characteristics. Since such activities are

undertaken mainly by secondary market participants, including major investment banks, the

issue is not directly relevant to the primary market participant issue of whether to retain or

securitize.

If lenders wish to reduce regulatory capital requirements, transfer credit and interest

rate risk, and increase liquidity, then we would expect to see most loans securitized. On

the other hand, if firms prefer diversification to specialization, they may retain some

percentage of the loans in their portfolio (see Winton (2000) for a discussion of diver-

sification versus specialization in lending). If existing risk-based capital rules require too

much capital for low-risk loans and too little capital for high-risk loans, we would expect

to see the low-risk loans securitized and the high-risk loans retained in portfolio.

Furthermore, since banks typically have ongoing contracts to sell loans to one of the

two major government sponsored enterprises operating in the secondary market, they

have an interest in maintaining their reputation for credit quality so as not to lose market

access. This repeated game structure with a relatively limited set of loan buyers

reinforces our expectation that securitized loans should be relatively safer than those

retained in portfolio. Unfortunately, we are unable to separate the reputation hypothesis

from the regulatory capital arbitrage hypothesis in our empirical tests: both hypotheses

predict that securitized loans should have lower default rates than loans retained in

portfolio.

6 Although the presence of asymmetric information and risk are correlated, they are not the same.

116 AMBROSE ET AL.

In this paper, we empirically examine the ex-post performance of securitized and

unsecuritized loans with the goal of determining whether securitization is a natural by-

product of information asymmetries present in the loan market or whether securitization

occurs in response to lender incentives resulting from bank capital regulations or a

concern for reputation. Our analysis is based on approximately 14,000 mortgage loans

originated between 1995 and 1997 and observed through October 2000. These loans

represent a broad spectrum of the mortgage market (both conventional and jumbo) with

approximately 95 percent being ultimately securitized. Our empirical analysis follows a

two-step process. First, we estimate a competing risks hazard model of mortgage

termination based on the prepayment and default status of the mortgages originated in

1995 and 1996 using only data available at the time of mortgage origination. The purpose

of this first step is to estimate a model that will provide a prediction of the prepayment

and default probability for mortgages originated in 1997. The second step of our analysis

uses these predicted probabilities as explanatory factors in assessing the probability that a

mortgage originated in 1997 is either securitized or held in portfolio. This mortgage

securitization model also includes a measure of whether the loans have relatively high or

low origination effective yield spreads, thus providing a means for testing whether

lenders use asymmetric information in making securitization decisions.

To preview the empirical findings, we find that higher risk loans are indeed retained in

portfolio, while lower risk loans are securitized, confirming the implications of Calem

and LaCour-Little (2004) and DeMarzo and Duffie (1999). Although the results from our

study appear to support the regulatory capital arbitrage or the repeated games reputation

hypotheses, it is important to remember that these data represent a relatively small

portion of the overall volume of mortgage origination activity by a single lender and,

thus, may not generally apply to the broader market.

1. Data

The data used for this research consist of event histories on 14,285 conventional fixed

rate mortgages originated between January 1995 and December 1997 and followed

through October 2000. Both conforming and non-conforming loans are included,

Table 1. Distribution of mortgage loans by origination year

This table reports the frequency distribution by year for the sample of 14,285 conventional fixed rate mortgage

loans originated between January 1995 and December 1997 by a national lender that prefers anonymity. Both

conforming and non-conforming loans are included, although super-jumbos (loans with initial balances in

excess of $650,000) are not. Loans were originated throughout the United States and were tracked from

origination through October 2000.

Year Frequency Percent

Mortgage outcome

Prepaid Default Still active

1995 4,695 32.9 2,048 340 2,307

1996 3,265 22.9 1,421 167 1,677

1997 6,325 44.3 1,700 380 4,245

Total 14,285 100.0 5,169 887 8,229

SECURITIZATION 117

although super-jumbos (loans with initial balances in excess of $650,000) are not. Loans

were originated throughout the United States. Table 1 reports the distribution of the loans

by origination year and outcome.

Table 2 shows the geographic distribution of the sample. Since our data come from a

single lender, we compared the sample distribution to the MIRS and Home Mortgage

Disclosure Act (HMDA) databases. The distribution of mortgage originations across

years follows a pattern similar to that observed in the broader market. However, the

comparison indicates that our sample is somewhat overrepresented by loans in the

New York/New Jersey region and underrepresented in the Northwest and Southwest

regions.7

We have relatively complete micro-level data for each loan in the sample, including

geographic location, loan amount, note rate, and points paid at time of loan origination.8

We also observe major credit quality indicators, including loan-to-value ratio (LTV ) and

borrower credit score at time of origination (FICO).9 Borrower characteristics available

include age (BRWAGE) and income (INCOME). Table 3 reports the descriptive statistics

for the sample, segmented by origination year and outcome. In general, we find that loans

sold to the GSEs had lower loan-to-value ratios at origination than loans held in portfolio

or sold as private-label MBS. Across origination years, we see a general decline in LTV

in the later years, which is consistent with greater refinancing activity in 1996 and 1997 than

in 1995.

Table 2. Distribution of mortgages across origination year, geographic region and by outcome (percent

of total loans originated in each year by region and outcome)

HUD region

Held in portfolio Sold to GSE Sold to private label

1995 1996 1997 1995 1996 1997 1995 1996 1997

1: New England 2.8% 1.2% 1.6% 3.5% 3.4% 4.2% 1.8% 4.8% 6.8%

2: New York/New Jersey 35.0% 65.2% 65.8% 34.0% 37.5% 35.7% 24.0% 29.2% 28.7%

3: Mid-Atlantic 6.5% 9.9% 11.9% 7.2% 7.4% 9.9% 11.4% 14.7% 12.5%

4: Southeast 3.5% 4.3% 6.2% 10.9% 11.9% 11.3% 6.0% 6.0% 5.7%

5: Midwest 17.6% 6.8% 2.6% 19.0% 19.8% 16.7% 12.1% 13.9% 12.7%

6: Southwest 0.0% 0.6% 0.0% 6.4% 3.5% 4.0% 0.9% 1.5% 1.3%

7: Great Plains 7.8% 1.2% 0.5% 6.4% 3.5% 2.6% 2.0% 0.2% 1.0%

8: Rocky Mountain 0.0% 0.6% 1.0% 1.9% 1.2% 1.4% 0.1% 1.1% 1.1%

9: Pacific 26.7% 9.9% 10.4% 9.7% 11.2% 13.3% 41.7% 28.3% 29.9%

10: Northwest 0.0% 0.0% 0.0% 0.9% 0.6% 0.9% 0.0% 0.3% 0.4%

Total Loans 397 161 193 2930 2485 4831 1368 619 1301

7 The Appendix provides a table detailing the comparison of our sample with the broader market.

8 Points paid at origination refers to the practice of charging borrowers interest at the time of mortgage

origination where one point equals 1 percent of the loan amount. The combination of points paid at

origination and the mortgage contract rate determine the effective yield (or cost) of the mortgage at

origination.

9 Borrower credit quality is measured by the credit score obtained from Fair, Isaac and Company (FICO).

Higher scores indicate high-quality borrowers and lower scores indicate lower quality.

118 AMBROSE ET AL.

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SECURITIZATION 119

In general, credit quality appears to have increased year over year, with declining

LTVs and increasing credit scores. However, we note that differences do exist across

the three samples. In general, borrower credit quality is lower for loans held in portfolio

and highest for loans sold to the GSEs. For example, in 1997 borrower credit scores

averaged 693 for loans held in portfolio versus 719 for loans sold to the GSEs. We also

find smaller differences in borrower age at origination (our proxy for wealth), with

loans sold to the GSEs having a higher average borrower age. However, loans sold to

the GSEs have lower average borrower income at origination. Consistent with housing

market appreciation, loan amounts increased over time, and we find that loan amounts

for loans sold as private-label MBS are consistently greater than loans held in portfolio

or sold to the GSEs. For example, loans sold as private label had an average balance

in 1997 of $264,900, while the average loan balance for loans held in portfolio was

$123,600.

Overall, we note that 72 percent (10,246) of the loans were sold to the GSEs, 23

percent (3,288) were sold as private-label MBS, and 5 percent (751) were retained in the

lender’s portfolio. However, the breakdown by origination year indicates a subtle trend

away from retaining loans in portfolio. For example, in 1995 we see that 8.5 percent of

loans originated were retained in portfolio, but by 1997, only 3.1 percent of the loans

originated that year were retained. As a result, we see a corresponding increase in the

percentage of loans that were sold into the secondary market.

We can identify at least two possible reasons for this shift in loan disposition. First, it

could simply result from changes in average borrower characteristics over time, with

more borrowers meeting secondary market standards seeking loans in 1997 than in 1995.

This would be consistent with the observed increase in mortgage refinancing that

occurred during 1997 as interest rates fell. On the other hand, the observed change in

loan disposition may represent a shift in risk preferences by the lender.

Table 3 also reports the average mortgage yield spread at origination (YLDSPD),

calculated as the effective mortgage yield, including the effect of any points paid at

origination and assuming a 10-year holding period, less the 10-year constant maturity

Treasury rate. We note that loans held in portfolio have higher origination spreads and

that the spreads on loans sold into the secondary market (either as private label or to the

GSEs) are roughly the same. However, we do note a general decline in the origination

spread over the three-year period.

2. Ex-post defaults and prepayments on securitized and portfolio loans

In this section, we estimate an empirical model of prepayment and default using

borrower information available to the lender at the time of underwriting. The purpose of

this model is to estimate a priori prepayment and default probabilities for each borrower.

We use these estimated probabilities in the next section to examine the risk profile of

loans that are securitized versus those that are retained in portfolio.

It is well known that a mortgage borrower has the option to prepay the mortgage,

default, or continue the mortgage by making the payment due. In estimating a competing

120 AMBROSE ET AL.

risks model, we denote mortgages that are still current at the end of the observation

period as censored. Thus, we define Tj ( j = 1, 2, 3) as the latent duration for each loan to

end during the observation window by prepaying, defaulting, or being censored and the

observed duration, � , is the minimum of the Tj.

Conditional on a set of explanatory variables, xj, that include personal characteristics

as well as market conditions at the time of origination, and parameters, �j, the probability

density function ( pdf ) and cumulative density function (cdf ) for Tj are

fj Tj xj; �j

��

� �

¼ hj Tj xj; �j

��

� �

exp �Ij rj xj; �j

��

� �� �

; ð1Þ

Fj Tj xj; �j

��

� �

¼ 1� exp �Ij rj xj; �j

��

� �� �

; ð2Þ

where r is an integer variable taking values in the set {1,2,3} representing the three

possible outcomes, Ij is the integrated hazard for outcome j:

Ij Tj xj; ���

� �

¼Z Tj

0

hj s xj; �j

��

� �

ds, ð3Þ

and hj is the hazard function.

The joint distribution of the duration and outcome is

f �; j x; �jð Þ ¼ hj � xj; �j

��

� �

exp �I0 � x; �jð Þð Þ, ð4Þ

where x = (x1, x2, x3), � = (�1, �2, �3) and I0 =P

Ij is the aggregated integrated hazard.

Thus, the conditional probability of an outcome is

Pr j �; x; �jð Þ ¼hj � xj; �

��

� �

P3

j¼1

hj � x; �jð Þ: ð5Þ

To simplify estimation, we specify a separate exponential hazard function for each

mortgage outcome

hj �j xj; �j

��

� �

¼ exp x 0j�j

� �

, ð6Þ

and estimate (5) in a multinomial logit framework.

Since the purpose of the competing risks model is to obtain an unbiased expectation of

borrower prepayment and default risk, we divide our sample into an estimation sample

and a holdout sample. We estimate (5) using the estimation sample. Using the estimated

coefficients, we then calculate the predicted prepayment and default probabilities for the

loans in the holdout sample. This scheme avoids introducing bias into the subsequent

analysis by using ex-ante outcome probabilities based on ex-post realizations. To only

SECURITIZATION 121

use information (or statistical inferences) available at loan origination, we place all loans

originated in 1995 or 1996 in the estimation sample and reserve the loans originated in

1997 as the holdout sample. Thus, we are using information about loans originated in

1995 and 1996, and followed for up to six years after origination, to develop empirical

prepayment and default models that will be used to calculate predicted prepayment and

default probabilities for loans originated in 1997.

Table 4 presents the parameter estimates of the competing risks model estimated from

the estimation sub-sample. Again, our purpose here is to obtain forward-looking pre-

payment and default probabilities, and thus, we only use information about the borrower

that was available at origination. Therefore, the set of explanatory variables (xj) includes

the borrower’s credit score (FICO) at origination, the borrower’s age and income at

origination (BRWAGE and INCOME ), the mortgage loan-to-value ratio at origination

(LTV ), the discount points paid by the borrower at origination (DISCPTS ), and a dummy

variable indicating whether the loan was eligible for sale to the GSEs at origination

Table 4. Competing risks model of mortgage outcome

Pr j �; x; �jð Þ ¼ hj � xj ;�jð ÞP3

j¼1

hj � x;�jð Þ

The competing risks model is estimated as a multinomial logit model assuming a quadratic baseline hazard

function. The odds ratio estimates are calculated as e� and provide an indication of the sensitivity of the

estimated probabilities to a change in that variable.

Variable Label

Coefficients Odds ratio estimates

Prepay Default Prepay Default

Intercept j8.521*** (814.93) j7.011*** (84.39)

FICO Fair Isaac Credit Score 0.002*** (26.90) j0.008*** (117.11) 1.00 0.99

BRWAGE Borrower Age j0.014*** (63.07) 0.002 (0.24) 0.99 1.00

INCOME Borrower Income 0.001*** (35.36) j0.002** (3.89) 1.00 1.00

LTV Loan-to-value Ratio j0.631*** (29.93) 1.178*** (10.25) 0.53 3.25

DISCPT Discount Points Paid at

Origination

j0.184*** (70.38) 0.014 (0.08) 0.83 1.01

q2 Non-judicial, No

Deficiency

0.212*** (20.14) 0.130 (1.29) 1.24 1.14

q3 Judicial & Deficiency 0.182*** (20.75) 0.011 (0.01) 1.20 1.01

q4 Judicial, No Deficiency 0.538*** (5.59) j9.291 (0.01) 1.71 <0.001

Conform 1 = conforming loan j0.037 (0.68) j0.264*** (5.92) 0.96 0.77

Time Number of months

since origination

0.232*** (1150.42) 0.271*** (178.28) 1.26 1.31

Time2 Time*Time j0.003*** (981.62) j0.003*** (146.18) 1.00 1.00

Likelihood Ratio

Statistic

2964.5***

(Chi-square statistics reported in parentheses)

***- Significant at the 1% level.

** -Significant at the 5% level.

* -Significant at the 10% level.

122 AMBROSE ET AL.

(CONFORM).10 Following Ambrose and Pennington-Cross (2000), who determine that

state mortgage laws are an important factor in determining the spatial distribution of

mortgage loans, we also include a set of dummy variables that classify states based on

judicial versus non-judicial foreclosure laws and deficiency versus non-deficiency

judgment states in order to control for differences in state laws regarding mortgage

default and foreclosure.11 q1 indicates states that have non-judicial foreclosure available

and allow lenders to obtain deficiency judgments;12 q2 indicates states that have non-

judicial foreclosure available but do not allow deficiency judgments;13 q3 indicates states

that require judicial foreclosure and allow deficiency judgments;14 and finally q4

indicates states that require judicial foreclosure and do not allow deficiency judgments.

Consistent with theoretical predictions, we note that the probability of prepayment

increases and the probability of default decreases with borrower credit quality. That is,

borrowers with higher FICO scores at origination are more likely to prepay and less

likely to default. The odds-ratio estimates indicate that every one point increase in

borrower credit quality at origination reduces the probability of default by 0.1 percent

and increases the probability of prepayment by a similar percentage. Furthermore, we

note that younger borrowers with higher incomes at origination have higher prepayment

probabilities. We see that the loan-to-value ratio at origination also has the expected

effect on prepayment and default, with the probability of prepayment declining and the

probability of default rising as the loan-to-value ratio at origination increases.

Furthermore, we see that discount points paid at origination have the expected impact

on prepayment. That is, borrowers who pay points are less likely to prepay.15 Not

surprisingly, given the underwriting guidelines established by Fannie Mae and

Freddie Mac, the competing risk estimation shows that mortgages that fall into the

Bconforming loan^ category have lower probabilities of prepayment and default.

Using the parameter estimates from table 4, we compute the predicted prepayment and

default probabilities for the borrowers in the holdout sub-sample. Table 5 reports the mean

predicted cumulative prepayment and default probabilities for 12, 24, 36, 48, and 60 months

after origination. Based on our estimated model, we find that the average probability of

prepayment for the first 12 months is 1.3 percent and the average probability of default is 0.1

10 Although we know the actual loan status at the time the dataset was created (i.e., whether sold to Fannie

Mae or Freddie Mac, sold to a private-label MBS, or retained in portfolio), we cannot precisely determine

whether the mortgage was conforming at origination. Thus, we classify a mortgage as conforming if it was

sold to the agencies, or if the borrower’s FICO score is above 660 and the loan amount was below the

conforming loan limit in place at time of origination and the LTV is either less than 80 percent or the loan

has private mortgage insurance if the LTV is greater than 80 percent.

11 Ambrose et al. (1997) provide theoretical justification for the impact of state borrower protection laws on

borrower prepayment and default propensity.

12 q1 indicates AL, AR, DC, GA, HI, MO, IA, MA, MD, MI, MS, RI, NE, NH, NM, NV, NY, TN, UT, VA,

WV, WY, CO.

13 q2 indicates AK, AZ, CA, ID, OK, ME, MN, MT, NC, OR, SD, TX, WA.

14 q3 indicates CT, DE, FL, IL, IN, KS, KY, NJ, OH, PA, SC, VT.

15 See Stanton and Wallace (1998) and Kau and Keenan (1987) for a discussion of the impact of mortgage

points on borrower prepayment.

SECURITIZATION 123

percent. As the mortgages season, the cumulative probability of prepayment rises to 44.4

percent by month 60 and the cumulative probability of default rises to 5.5 percent. These are

slightly higher default probabilities but lower prepayment probabilities, compared to

national averages for comparable vintages as reported by LoanPerformance.16

Table 5 also reports the predicted cumulative outcome probabilities based on the

disposition of the loan after origination. In general, we find that the prepayment proba-

bilities for mortgages retained in portfolio, sold to the GSEs, or sold as private-label

MBS are roughly the same. The prepayment probabilities for mortgages sold as private-

label MBS are slightly higher (46.2 percent by month 60 versus 44.1 percent for

mortgages sold to the GSEs or 39.2 percent for mortgages retained in portfolio).

However, we find that the probability of default is higher for mortgages retained in

portfolio than for loans sold to the secondary market. The cumulative probability of

default by month 60 is 8.7 percent for loans held in portfolio versus 5.1 percent for loans

sold to the GSEs and 6.7 percent for loans sold as private-label MBS. Again, this is

consistent with the observed pattern of the GSEs’ imposing tighter underwriting

standards on mortgages they will accept. In addition, the observed pattern is consistent

with our expectations concerning the loans that the lender would sell to the GSEs, given

the GSEs’ practice of requiring lenders to buy back defaulted mortgages if the default

experience is outside acceptable limits.

Table 5. Predicted cumulative prepayment and default probabilities

Predicted prepayment and default probabilities are calculated for each borrower in the holdout sample using the

estimated coefficients reported in table 4. Sample means reflect the expected cumulative prepayment and

default probabilities at 12, 24 36, 48, and 60 months since mortgage origination.

Full sample

N = 6,325

Held in portfolio

N = 193

Sold to GSEs

N = 4,831

Sold as

private label

N = 1,301

Mean Std. dev. Mean Std. dev. Mean Std. dev. Mean Std. dev.

Panel A: Cumulative Prepayment Probabilities

Month 12 0.013 0.003 0.011 0.003 0.013 0.003 0.014 0.004

Month 24 0.090 0.023 0.075 0.021 0.085 0.020 0.092 0.025

Month 36 0.245 0.056 0.215 0.067 0.242 0.053 0.259 0.064

Month 48 0.386 0.079 0.341 0.118 0.383 0.075 0.404 0.090

Month 60 0.444 0.087 0.392 0.144 0.441 0.083 0.462 0.099

Panel B: Cumulative Default Probabilities

Month 12 0.001 0.000 0.001 0.001 0.001 0.000 0.001 0.001

Month 24 0.006 0.004 0.009 0.006 0.005 0.003 0.007 0.005

Month 36 0.022 0.016 0.035 0.025 0.020 0.013 0.027 0.021

Month 48 0.043 0.031 0.068 0.048 0.040 0.026 0.053 0.041

Month 60 0.055 0.040 0.087 0.060 0.051 0.034 0.067 0.051

16 LoanPerformance reports current default rates for broad classes of loan categories and vintages, but not

cumulative rates. As of 2001, the current 90-day delinquency rate for conventional loans originated in

1995 was 1.53 percent and 1.47 percent for loans originated in 1996.

124 AMBROSE ET AL.

3. The decision to securitize

We now turn to the question of whether the predicted prepayment and default probabilities

have a systematic impact on the lender’s decision to securitize the loan. In the introduction,

we noted two possible theories for securitization. First, originators may wish to retain high-

default-risk loans and securitize low-default-risk loans in response to bank capital

regulations or reputation effects. Second, originators may take advantage of asymmetric

information to securitize less profitable loans (based on default and prepayment risk).17

With respect to the first theory, if bank capital regulations or lender reputation affect loan

portfolio decisions, then we would expect to find a positive relationship between expected

default probabilities and the probability of retaining the loan in portfolio. That is, high-

default-risk loans as revealed by higher expected default probabilities are more likely to

be retained in portfolio. The second theory suggests that originators will use inside

information to selectively securitize loans; that is, originators will securitize loans with

lower expected profitability. Here, the tradeoff between high risk (either prepayment or

default risk) and securitization is not as clear. The originator may find it more profitable

to keep higher-risk loans if the corresponding yield spread justifies the risk. This suggests

that we must examine the probability that a loan is retained in portfolio relative to

expected prepayment and default potential as well as loan yield spread at origination.

To determine whether a particular loan is over- or underpriced relative to other loans

originated by the lender, we follow Ambrose et al. (2004) and estimate an ordinary least

squares regression of the mortgage yield spread at origination. To control for char-

acteristics that affect mortgage yields, we follow the standard yield spread models

developed in the literature. We include independent variables loan amount; the mortgage

loan-to-value ratio; a dummy variable denoting whether the loan amount is above the

conforming loan limit; a dummy variable denoting whether the loan meets the GSE

conforming loan standards; the borrower’s credit quality score; a set of dummy variables

controlling for location; the current local house price and market interest rate volatilities;

the market credit risk premiumVdefined as the difference between the BAAA^ bond index

and the BBaa^ bond index; the yield curve slopeVcalculated as the difference between the

10-year and one-year Treasury bond rates; and a set of dummy variables that categorize

states based on judicial versus non-judicial foreclosure laws and deficiency versus non-

deficiency judgment states in order to control for differences in legal environment.18

Table 6 reports the results of the OLS regression estimation for the loans originated

in 1997 (the holdout sample). All coefficient estimates have the expected signs. From this

estimation, we collect the residuals to provide an indication of which loans are over- or

underpriced relative to the other loans originated in 1997. Based on the distribution of the

residuals, we categorize loans as being underpriced if the residual is negative and in the

17 Asymmetric information between the lender and MBS investors regarding individual borrower loans could

result from a variety of sources. For example, the lender could gather additional information about the

borrower that is not usually contained in the standard underwriting documents through the interview

process with the loan officer or if the borrower has a prior relationship with the lending institution.

18 McKenzie (2002) provides an extensive survey of efforts to model empirical mortgage yield spreads.

SECURITIZATION 125

bottom quartile of the distribution (low_spd = 1). We categorize loans as being over-

priced if the residual is positive and in the top quartile of the distribution (high_spd = 1).

To determine the probability that a loan will be held in portfolio, we estimate the

following logit model:

Pr Portfolio ¼ 1ð Þ ¼ �0 þ �1yldspd10þ �2 jumboþ �3cred spd þ �4yldcurve

þ �5�r þ �6prepayþ �7default þ �8prepay*low spd

þ �9prepay*high spd þ �10default*low spd

þ �11default*high spd þ ", ð7Þ

Table 6. Yield spread regression

Ordinary least squares (OLS) regression of mortgage yield spread at origination. The mortgage yield spread

(YLDSPD10) is the effective mortgage yield, including the effect of points calculated over a 10-year holding

period, less the 10-year constant maturity Treasury rate. Independent variables are the loan amount (logbal ),

the mortgage loan-to-value ratio (logltv), a dummy variable denoting whether the loan amount is above the

conforming loan limit ( jumbo), a dummy variable denoting whether the loan meets the GSE conforming loan

standards (conform), the borrower’s credit quality score (log fico), a set of dummy variables controlling for

location (midwest, south, west), the current local house price (loghpistd ) and market interest rate (logsiggs10)

volatilities, the market credit risk premium (logcredit)Vdefined as the difference between the BAAA^ bond

index and the BBaa^ bond index, the yield curve slope (logyldcurve)Vcalculated as the difference between the

10-year and one-year Treasury bond rates, and a set of dummy variables that categorize states based on judicial

versus non-judicial foreclosure laws and deficiency versus non-deficiency judgment states in order to control

for differences in legal environment (q2,q3,q4).

F-statistic: 88.7***

Adjusted R2: 0.1722

N = 6,325

Variable Parameter Estimate t Value Pr > |t |

Intercept 9.165*** 22.51 <0.0001

Conform j0.036*** j3.29 0.001

Jumbo 0.112*** 8.12 <0.0001

Logltv j0.020** j2.38 0.017

Logcredit j0.533*** j4.81 <0.0001

Logfico j0.165*** j5.95 <0.0001

Logbal j0.109*** j20.10 <0.0001

Loghpistd 0.006 0.75 0.452

logsiggs10 16.604*** 16.43 <0.0001

Logyldcurve j0.537*** j22.97 <0.0001

q2 j0.010 j1.00 0.318

q3 0.025*** 3.88 0.000

q4 j0.015 j0.46 0.644

South j0.039*** j4.71 <0.0001

Midwest j0.002 j0.20 0.839

West 0.010 0.91 0.364

***- Significant at the 1% level.

** -Significant at the 5% level.

* -Significant at the 10% level.

126 AMBROSE ET AL.

where prepay and default are the cumulative 24-month prepayment and default proba-

bilities estimated from (5), and low_spd and high_spd are the indicator variables

calculated from the residuals of the yield spread regressions indicating whether the actual

mortgage yield spread is low or high relative to the predicted yield spread. Thus,

equation (7) controls for the lender’s expectation of default and prepayment risk at

the time of origination as well as the interaction of risk expectations and price.

The variables cred_spd, yldcurve, and �r are macroeconomic variables that represent the

market credit spread, slope of the yield curve, and interest rate volatility at loan

origination. We calculate cred_spd as the yield difference between Moody’s FAAA_ and

FBaa_ bond indices. The yield curve slope is estimated as the difference between the

10-year and one-year Treasury bond rates. We use the standard deviation in the one-year

Treasury bond rate over the 24 months prior to origination as a proxy for the expected

volatility in the risk-free interest rate. Including these variables allows us to test for

market conditions that may lead to increased probability for securitization. We also

include the mortgage yield spread ( yldspd10) and a dummy variable controlling for

whether the loan amount is above the conforming loan limit ( jumbo). Although our

variables are measured at the time of origination, we recognize that the time of securitization

may not necessarily coincide with the date of origination. Unfortunately, we do not know the

date of securitization; as a result, the time lag between origination and securitization may

introduce noise to the model specification. However, industry practice is to limit adverse

interest rate risk by securitizing loans quickly after origination.19 Thus, we do not anticipate

that the time lag between origination and securitization is serious.

Table 7 reports the parameter coefficients for the generalized logit estimation of (7).

The model estimates the probability that the loan will be retained in the lender’s portfolio

versus being sold into the secondary market (either to the GSEs or as private-label MBS).

Consistent with the expectations that secondary market players effectively bid away

loans that meet their underwriting standards, the coefficient for the expected 24-month

default probability is significantly positive. This indicates that loans with higher expected

default probabilities are more likely to be retained in portfolio and less likely to be sold

into the secondary market. The expected probability of prepayment is significantly

negatively related to the decision to retain the loan. That is, loans with higher expected

prepayment rates are less likely to be retained and more likely to be securitized. These results

are consistent with the theory that lenders have an incentive to retain higher risk loans in

portfolio.

Turning to the interaction of the default and prepayment probabilities with the

indicator of over- or underpricing, we find that the interaction of prepayment and low

spread is highly significant. This suggests that for loans with actual yield spreads less

than spreads predicted by our model, the probability of being retained in portfolio

increases as the expected prepayment probability increases. In other words, loans with

higher prepayment probabilities and yield spreads lower than expected are more likely to

19 Furthermore, accounting regulations require that lenders classify loans at origination as either being

held in portfolio or held for sale. Loans classified as held for sale are required to be marked-to-market

and thus are normally securitized within 90 days of origination in order to reduce interest rate risk.

SECURITIZATION 127

be held in portfolio. Interestingly, the interactions of expected default probabilities with

the residual spread indicators are not significant. Thus, we do not find evidence that the

originator is using asymmetric information to selectively retain high-yielding, low-risk

mortgages.20 However, we do find evidence that the originator is selectively retaining

mortgages based on expected prepayment. Given that the mortgage yields were calculated

assuming a constant 10-year holding period, early prepayment has the impact of

increasing the lender’s yield. Thus, the results indicate that the originator may be

retaining mortgages that the market has undervalued (actual yield spreads are lower than

predicted yield spreads) but have a higher probability of realizing a boost in yield through

early prepayment.

20 This result is consistent with the theoretical predictions of Passmore and Sparks (1996).

Table 7. Impact of expected prepayment and default probabilities on securitization

Estimated coefficients of the following logit model of the probability that a loan is retained in portfolio:

Pr Portfolio ¼ 1ð Þ ¼ �0 þ �1yldspd10þ �2 jumboþ �3cred spd þ �4yldcurveþ �5�r

þ �6prepayþ �7default þ �8prepay*low spd þ �9prepay*high spd

þ �10default*low spd þ �11defaults*high spd þ "

prepay and default are the estimated cumulative 24-month prepayment and default probabilities, low_spd

and high_spd are dummy variables calculated from the residuals of the yield spread regression indicating

whether the actual mortgage yield spread is low or high relative to the predicted yield spread, cred_ spd is

the yield difference between Moody’s BAAA^ and BBaa^ bond indices, yldcurve is estimated as the difference

between the 10-year and one-year Treasury bond rates, �r is the standard deviation in the one-year Treasury

bond rate over the 24 months prior to origination, yldspd10 is the mortgage yield spread at origination, jumbo is

a dummy variable controlling for whether the loan amount is above the conforming loan limit. Of the 6,325

loans originated in 1997, 6,132 (96.9%) were securitized and 193 (3.1%) were retained in portfolio.

Variable Label Parameter Chi-Sq Odds ratio

Intercept Effective yieldV10-yr Treasury Rate j6.485*** 9.46

Yldspd10 3.055*** 93.90 21.22

Jumbo j0.018 0.01 0.98

cred_spd Credit Spread (BBB-AAA) j7.148* 2.64 <0.001

Yldcurve Yield Curve 2.046*** 9.58 7.74

sig_ gs1 Interest Rate Volatility 7.378*** 7.92 >999

cum_prepay24 Predicted Prepayment j24.495*** 23.79 <0.001

cum_default24 Predicted Default 87.532*** 22.54 >999

cum_prepay24*low_spread 20.855*** 34.36 >999

cum_prepay24*high_spread 2.314 0.38 10.11

cum_default24*low_spread j30.986 1.86 <0.001

cum_default24*high_spread j12.248 0.21 <0.001

Likelihood Ratio Statistic 286.6***

***- Significant at the 1% level.

** -Significant at the 5% level.

128 AMBROSE ET AL.

Finally, we observe that loans originated during periods with increased credit spreads are

less likely to be retained in portfolio. This is consistent with investor Bflight to quality^during periods of economic uncertainty, resulting in reduced demand for mortgages in the

secondary market. Furthermore, we note that loans originated in periods with steeper yield

curves are more likely to be retained in portfolio. A steeper yield curve implies an

economic environment in which there is a greater reward for funding long-term assets with

short-term liabilities. Together, the coefficients on expected default probability and

economic conditions are consistent with the theory that lenders are retaining higher-risk

mortgages in portfolio in response to bank capital regulations, to maximize efficient capital

use, or to preserve their reputation for credit quality in the secondary market.

4. Summary and Conclusions

Banks have the choice of securitizing loans that they have originated or retaining them in

portfolio. While there are many reasons to securitize loans in the secondary market, there

are countervailing reasons for retaining them in portfolio. Among the reasons for

retaining loans are favorable performance expectations based on the lender’s private

information (asymmetric information).

On the other hand, secondary market participants such as Fannie Mae and Freddie Mac

have strict underwriting criteria for purchasing loans, and in a repeated game framework,

it is difficult to justify the asymmetric information hypothesis. Rather, we would expect

banks to retain loans that secondary market participants do not want to purchase (which

includes loans with higher risk than secondary market participants are willing to bear).

Moreover, if Calem and LaCour-Little (2004) are correct that existing risk-based capital

requirements for most mortgage loans are too high, lenders would have an incentive to

sell lower-risk and retain higher-risk assets in portfolio.

In the empirical work presented here, we find evidence that lenders do indeed retain

higher-risk loans for their portfolio while selling lower-risk loans into the secondary

market. Furthermore, we find that riskier loans (loans having higher expected prepay-

ment and default probabilities) are more likely to be sold as private-label MBS. Thus, our

analysis supports the regulatory capital arbitrage and reputation explanations offered for

asset securitization.

Acknowledgments

We would like to thank Wayne Passmore, Dan Quan, Bob Van Order, John Quigley, and

the seminar participants at Rice University, Cambridge University, and the University of

Wisconsin at Madison for their helpful comments and suggestions. Earlier versions of

this paper were presented at the 2003 AREUEA International meeting in Cracow,

Poland, and at the 2004 Cambridge-Maastricht Conference. Any errors are the re-

sponsibilities of the authors.

SECURITIZATION 129

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AP

PE

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IX130 AMBROSE ET AL.

Reg

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%

SECURITIZATION 131

Ta

ble

A.1

.(c

on

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).

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te

Sam

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19

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8

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%

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28

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40

40

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24

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10

63

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13

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48

93

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61

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81

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86

11

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93

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14

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1,8

47

13

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22

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51

6.7

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2,9

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Reg

ion

10

AK

70

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50

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19

0.3

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10

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32

0.0

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20

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10

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22

50

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93

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50

61

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12

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1,9

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13

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24

70

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44

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%

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42

0.3

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2,1

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2.5

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7,7

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2.6

%

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90

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21

0.3

%3

70

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2,9

67

3.8

%4

,04

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.7%

8,1

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6.0

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5.1

%

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tal

72

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5.4

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28

16

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83

81

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81

4.6

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%

To

tal

All

4,6

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0.0

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51

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25

10

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4,2

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7,1

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7,5

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10

0.0

%

132 AMBROSE ET AL.

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Greenspan, Alan. BThe Role of Capital in Optimal Banking Supervision and Regulation.^ Federal Reserve

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Kau, J.B., and D.C. Keenan. BTaxes, Points, and Rationality in the Mortgage Market.^ AREUEA Journal

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Korrell, Mark. BThe Workings of Private Mortgage Bankers and Securitization Conduits.^ In: Leon Kendall

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McKenzie, Joseph A. BA Reconsideration of the Jumbo/Non-Jumbo Mortgage Rate Differential.^ Journal of

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SECURITIZATION 133