Using a representative sample of RMBS deals from the pre-crisis period, we show that deals with a higher level of equity tranche have significantly lower foreclosure rates that cannot be explained away by observable credit risk factors of the underlying loan pool. Further, securities that are sold from high-equity-tranche deals command higher prices conditional on their credit ratings. These results show that the equity tranche served as a signal of the unobserved pool quality of these deals. In addition, consistent with theoretical models of pooling , the level of the AAA-rated tranche is significantly higher for pools that bundle loans with commonality in their private information but with uncorrelated risks. Our results highlight the effectiveness of security design solutions in mitigating informational frictions even during the build-up of the subprime mortgage crisis.

While there is a large body of research on conflicts of interests in the residential mortgage-backed securitization (RMBS) market prior to the financial crisis of 2007-09, there is surprisingly little empirical research on how these financial instruments may have mitigated contracting frictions through security design (see Keys, Piskorski, Seru, and Vig (2012),Gorton  (2012) for recent surveys). Economic theory suggests that market participants can use the level of equity tranche retention as a costly signal of unobserved asset quality to mitigate the effect of information asymmetry between deal sponsors and investors. However, several market observers have noted that such mechanisms completely lost their relevance during the pre-crisis period because deal sponsors were able to subsequently off load the equity tranche in secondary markets. Whether such contracting devices had any meaningful effect on market outcomes, therefore, remains an empirical issue that has not yet been analyzed. This paper aims to fill this gap in the literature.