The recent crisis in the mortgage market is having an enormous impact on the world economy. While the popular press has presented a number of anecdotes and case studies, a body of academic research is fast evolving to understand the precise causes and consequences of this crisis (see Greenlaw et al., 2008; Brunnermeier, 2008). Our study contributes to this growing literature by analyzing the effect of banks’ participation in the originate-to-distribute (OTD) method of lending on the crisis. We show that the transfer of credit risk through the OTD channel resulted in the origination of inferior quality mortgages. This effect was predominant among banks with relatively low capital and banks with lesser reliance on demand deposits.

As efficient providers of liquidity to both consumers and firms (Diamond and Dybvig, 1983; Holmstrom and Tirole, 1998; Kashyap, Rajan, and Stein, 2002), as better ex-ante screeners (Leland and Pyle, 1977; Boyd and Prescott, 1986), or as efficient ex-post monitors (Diamond, 1984), banks perform several useful functions to alleviate value relevant frictions in the economy. On the asset side of their balance sheet, they develop considerable expertise in screening and monitoring their borrowers to minimize the costs of adverse selection and moral hazard. It is possible that they are not able to take full advantage of these expertise due to market incompleteness, regulatory reasons, or some other frictions. For example, regulatory capital requirements and frictions in raising external capital might prohibit a bank from lending up to the first best level (Stein, 1998).