Hiding behind Writing: Communication in Offering Process and MBS Performance

Abstract Securities Offering Reform (SOR) in 2005 formalized free writing prospectus (FWP) as permittable written communication in the offering process by securities issuers. Using non-agency mortgage deals securitized following SOR, we find the surprising result that MBS deals with more usage of FWPs sufferred up to 20% higher cumulative net loss. Using textual analysis as an identification strategy, we attribute our finding to the more aggressive sales tactic associated with more FWP usage being employed for deals with more adverse information withholding. Consequently, the cumulative net loss on these deals are worse than their reported characteristics. Lending support to this explanation, we find that the FWP effect persists even after controlling for deal initial yield spreads and credit enhancements, and higher usage of FWPs are associated with increased content ambiguity in the final prospectus. The latter is a tactic often used to hedge litigation risk on undisclosed information. Keywords: Written Communication, Free Writing Prospectus, Information withholding, Uncertain Text, MBS Performance * We thank Zhonglan Dai, Jun Li, Tim Loughran, and Han Xia for helpful comments. All three authors are from Naveen Jindal School of Management, University of Texas at Dallas, 800 West Campbell Road, Richardson, Texas, 75080, email: [email protected], [email protected], [email protected] "In many ways, mortgage products such as RMBS were ground zero in the financial crisis. Misrepresentations in connection with the creation and sale of mortgage securities contributed greatly to the tremendous losses suffered by investors once the U.S. housing market collapsed.&quot

Hiding behind Writing: Communication in the Offering Process of Mortgage-Backed Securities

Abstract Securities Offering Reform (SOR) in 2005 formalized free writing prospectus (FWP) as permittable written communication in the offering process by securities issuers. Using non-agency mortgage deals securitized following SOR, we find the surprising result that MBS deals with more FWP usage suffered up to 2% higher cumulative net loss, accounting for almost 18% of the deal average loss. Examining the contents of FWPs, we uncover that textual FWPs rather than loan data tape played a more significant role for the larger deal losses. More FWPs are associated with increased uncertain text usage in the final prospectus supplements, a tactic often used to hedge litigation risk on undisclosed information. Our findings provide evidence that MBS issuers may have hidden information behind writing for their financial benefits. Keywords: Written Communication, Free Writing Prospectus, Information Withholding, Uncertain Text * We thank Dion Bongaerts, Zhonglan Dai, Kathleen Weiss Hanley, Jun Li, Tim Loughran, Han Xia, and the seminar participants at Erasmus University for helpful comments. All three authors are from Naveen Jindal School of Management, University of Texas at Dallas, 800 West Campbell Road, Richardson, Texas, 75080, email: [email protected], [email protected], [email protected] "In many ways, mortgage products such as RMBS were ground zero in the financial crisis. Misrepresentations in connection with the creation and sale of mortgage securities contributed greatly to the tremendous losses suffered by investors once the U.S. housing market collapsed.&quot