Bank monitoring incentives and optimal CDOs

The paper examines a delegated monitoring problem between investors and a bank holding a portfolio of correlated balloon loans displaying “contagion.” Moral hazard prevents the bank from monitoring continuously unless it is compensated with the right incentive-compatible contract. Under the MonotoneLikelihood-Ratio Property (MLRP), the asset pool is liquidated when losses exceed a cut-off rule. The bank bears a relatively high share of the risk initially, as it should have high-powered incentives to monitor, but its long term financial stake tapers off as losses unfold. Securitization can approximate the optimal contract. The sponsor provides the trust with credit enhancement in the form of a weighted portfolio of collateralized debt obligations which is funded by the proceeds of the sale and extends into the cut-off rule. In compensation the trust pays servicing fees as well as rent-preserving fees if the sponsor has a high discount rate. Rather than being detrimental, well-designed securitization seems an effective and convenient means of implementing the second best.