This paper documents that complex financial innovations like collateralized debt obligations (CDOs) enabled informed parties in the commercial mortgage-backed securitization pipeline to reduce their skin-in-the-game in a way not observable to other market participants. This reduction in first-loss security retention significantly impacted the probability that more senior tranches ultimately defaulted. We show that this performance is entirely driven by the amount of first-loss sold to (affiliated) CDOs within 12 months of the commercial mortgage-backed securities (CMBS) deal. Our result is robust to using the differential access of first-loss investors to CDO funding as an instrument to identify exogenous variations in the retention of first-loss securities.

This paper shows how the intraday allocation and pricing of overnight loans of federal funds reflect the decentralized interbank market in which these loans are traded. A would-be bor-rower or lender typically finds a counterparty institution by direct bilateral contact. Once in contact, the two counterparties to a potential trade negotiate terms that reflect their incentives for borrowing or lending, as well as the attrac-tiveness of their respective options to forego a trade and to continue “shopping around. ” This over-the-counter (OTC) pricing and allocation mechanism is quite distinct from that of most centralized markets, such as an electronic limit order book market in which every order is anony-mously exposed to every other order with a cen-tralized order-crossing algorithm. While there is a significant body of research on the microstructure of specialist and limit order book markets, most OTC markets do not have comprehensive transaction-level data available for analysis. The federal funds mar-ket is a rare exception. We go beyond a previ-ous study of the microstructure of the federal funds market (Craig H. Furfine 1999) by model-ing how the likelihood of matching a particular borrower with a particular lender, as well as the interest rate that they negotiate, depend on their respective incentives to add or reduce balances and their ability to conduct further trading with other counterparties (proxied by the level of their past trading volumes). Our results are consistent with the thrust of search-based OTC financial

We present and discuss preliminary evidence suggesting that credit ratings significantly influenced prices for subprime mortgage-backed securities issued in the period leading up to the recent financial crisis. Ratings are closely correlated with prices even controlling for a rich set of security- and loan-level controls. This incremental variation in ratings has much less predictive power for security defaults, however, based on findings to date from our ongoing research, suggesting prices were excessively sensitive to ratings relative to their informational content.