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Innovations in Credit Risk Transfer: Implications for Financial Stability

We approximate credit risk developments at the bank level by considering non- performing loans of each institution and rating changes at the individual security level. Importantly, our database allows us to identify not only the rating of these securities at the time of origination but also their evolution over time. We also analyze to what extent housing prices, securitization activity and lending may have asymmetric effects across institutions and geographically (at the regional level) by identifying the role of each of these factors. Our results suggest that credit developments in Spain were not that different from those experienced. | Innovations in Credit Risk Transfer Implications for Financial Stability1 Darrell Duffie Stanford University Draft July 2 2007 Banks and other lenders often transfer credit risk in order to liberate capital for further loan intermediation. Beyond selling loans outright lenders are increasingly active in the markets for syndicated loans collateralized loan obligations CLOs credit default swaps credit derivative product companies specialty finance companies and other financial innovations designed for credit risk transfer. My purpose here is to explore the design prevalence and effectiveness of credit risk transfer. My focus will be the costs and benefits for the efficiency and stability of the financial system. In addition to allowing lenders to conserve costly capital credit risk transfer can improve financial stability by smoothing out the risks among many investors. 1I am grateful for motivation from Claudio Borio and for initial conversations with Richard Cantor Mark Carey Larry Forest Michael Gordy Serena Ng David Rowe and Kevin Thompson. I am especially grateful for research assistance by Cliff Gray and Andreas Eckner and for technical assistance from Linda Bethel and Nicole Goh. I have benefited from comments many of which remain to be reflected in a future draft by Tobias Adrian Scott Aguais Adam Ashcraft Jesper Berg Claudio Borio Eduardo Canabarro Richard Cantor Mark Carey Moorad Choudhry David Evans Larry Forest Michael Gordy Jens Hilscher Myron Kwast Joseph Langsam Sergei Linnik Alexandre Lowenkron Joseph Masri Matthew Pritsker Til Schuermann Hisayoshi Shindo David Shorthouse Roger Stein Kevin Thompson and Anthony Vaz. I have also benefited exceptionally by discussions provided by Kenneth Froot and Mohammed El-Erian at the Sixth Annual Conference of the Bank of International Settlements at Brunnen in June 2007 as well as from comments by others at this conference and at the Financial Advisory Roundtable of the New York Federal Reserve. Duffie is also with