Indirect Contagion in an Originate-to-Distribute Banking Model
In a model of Originate-To-Distribute (OTD) banking, I show that contagion may spread before any preference shock, fire sale, or change in haircuts takes place. The drivers of contagion are opaqueness of collateral and roll-over frequency. Complexity of structured finance and poor screening of borrowers induce both originators and investors at different stages of the OTD chain to develop heterogeneous expectations on the future value of securitized debt. When new information on the value of collateral is suffciently bad, creditors in the money market have to write down their loans to overoptimistic banks and shrink liquidity supply in the short-term. Banks with accurate pricing models are unable to roll over and go bankrupt for illiquidity reasons. I provide a set of conditions under which the industry is able to prevent contagion and policy makers shall commit to limit their intervention.
BEMPS - Bozen Economics & Management Paper Series, No. 21/2014