Confidence Banking and Strategic Default

Securitization relies on confidence. As a security is tied to a particular asset (or pool of assets), in principle the investor loses when the asset defaults. The issuer of the security, however, could promise to use the proceedings from other of its assets to cover the investor in such an event. Even though the issuer is not legally bound to fulfill its promise, it may have incentives to avoid default strategically to create a reputation of holding high quality assets. Booms and busts of securitization then depends on the determinants of reputation concerns, such as expectations about future profits, what makes it more volatile and more dependent on the issuer’s reputation than other forms of financing. I show this is consistent with historical evidence and suggest new regulations that exploit reputation concerns to stabilize securitization.