The paradox of safe asset creation

Safe asset demand increases loan risk. This arises in a competitive model in which securitization vehicles create safe assets by pooling loan payoffs purchased from loan originators. Equity investors allocate their wealth between originators, who need skin-in-the-game due to moral hazard, and vehicles, who need loss-absorption capacity against aggregate risk. An increase in demand for safety fosters safe asset creation through a securitization boom: originators sell more of their loan payoffs to vehicles, equity is reallocated from originators to vehicles, and the two effects contribute to an increase in loan risk. The model is consistent with a broad set of facts in the run-up to the Global Financial Crisis.