The Rise and Fall of Demand for Securitizations

At the heart of the recent financial crisis were nontraditional securitizations, especially collateralized debt obligations and private-label mortgage-backed securities backed by nonprime loans. Demand for these securities helped feed the housing boom during the early and mid-2000s, while rapid declines in their prices during 2007 and 2008 generated large losses for financial intermediaries, ultimately imperiling their soundness and triggering a full-blown crisis. Little is known, however, about the underlying forces that drove investor demand for these securitizations. Using micro-data on insurers' and mutual funds' holdings of both traditional and nontraditional securitizations, this paper begins to shed light on the economic forces that drove the demand for securitizations before and during the crisis. Among the findings, variation across securitization types and investors is key to understanding the crisis. Beliefs appear to have been an important driver of mutual fund holdings of nontraditional securitizations. Results also underscore the importance of optimal liquidity management in the context of fire sales. Key concepts include:

• Inexperienced mutual fund managers invested significantly more in these products than experienced managers.
• Beliefs-shaped by past firsthand experiences-played an important role. Managers who had suffered through the market dislocations of 1998 invested substantially less in nontraditional securitizations than those who had not.
• For insurance companies, incentives appear to have played an important role, though the nature of the relevant incentive conflict seems to have varied across small and larger insurance firms.