Loan Insurance, Market Liquidity, and Lending Standards

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Last updated: August 2020

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.