Competition, Product differentiation and Crises: Evidence from 18 million securitized loans

RMBS sponsors contributed to the rise of new product features in securitized mortgages prior to the 2008 financial crisis. Using a regulatory shock to sponsor competition, we show securitization influences the design of mortgage contracts, empirically demonstrating a unique, feedback loop of product differentiation from the derived security (MBS) to the underlying asset (loans). Product differentiation in Prime MBS collateral rises faster than that of non-prime in the early boom period (2000–2004), a strategic choice by MBS sponsors in the face of increasing competition. At very high levels of competition, product differentiation targets non-prime (marginal) borrowers. We develop a theoretical framework for sponsor-induced product differentiation that explains these empirical findings.