Signaling through security design: Evidence from Commercial Mortgage Backed Securities

We study the choice of how commercial mortgage securitizers comply with Dodd-Frank’s risk retention rule. We find that when securitizers retain a deal’s most junior tranches, collateral loan quality is worse and deal profitability is lower. We argue that these findings arise from a regulatory exemption allowing securitizers to sell these high-risk tranches, eliminating their credit exposure. Consistent with standard models, investors interpret this tranche selling as signaling lower-quality collateral. Our findings highlight how regulatory exemptions can undermine policymaker objectives and emphasize the need for regulators to anticipate how market participants will adjust their behavior in response to new rules.