DP14458 Loan Insurance, Market Liquidity, and Lending Standards

Author(s): Toni Ahnert, Martin Kuncl
Publication Date: March 2020
Date Revised: August 2020
Keyword(s): Adverse Selection, liquidity, Loan insurance, Risk transfer, screening
JEL(s): G01, G21, G28
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=14458

We examine loan insurance--credit risk transfer upon origination--in a model in which lenders can screen, learn loan quality over time, and can sell loans. Some lenders with low screening ability insure, benefiting from higher market liquidity of insured loans while forgoing the option to exploit future information about loan quality. Insurance also improves the quality of uninsured loans traded but lowers lending standards. We derive testable implications about loan insurance. Since lenders do not internalize its benefit for market liquidity, loan insurance is insufficient and should be subsidized. Our results can inform the design of government-sponsored mortgage guarantees.