Design of Financial Securities: Empirical Evidence from Private-Label RMBS Deals

Using a representative sample of Residential Mortgage-Backed Securities (RMBS), we show that deal sponsors use the equity tranche as a signal of the unobserved quality of opaque pools. Deals with higher level of equity tranche have signicantly lower foreclosure rates that cannot be explained away by observable credit risk or correlation structure of the loans in the underlying pool. Further, we analyze trade-os that are unique to bundling and tranching of loans in securitization deals as compared to the sale of a single asset. Consistent with DeMarzo’s (2005) model, we show that the extent of AAA-rated tranche is signicantly higher for pools that bundle loans with commonality in their private information but with uncorrelated risks. Overall, we uncover some of the key economic drivers of RMBS design and document contracting frictions that the design was able to mitigate even during the peak of the subprime mortgage market.