i
Executive Summary
Section numbers containing more detail are provided in [square] brackets.
•
Until very recently, the origination of mortgages and issuance of mortgage-backedsecurities (MBS) was dominated by loans to prime borrowers conforming to underwritingstandards set by the Government Sponsored Agencies (GSEs) [2]
−
By 2006, non-agency origination of $1.480 trillion was more than 45% larger thanagency origination, and non-agency issuance of $1.033 trillion was 14% larger thanagency issuance of $905 billion.
•
The securitization process is subject to seven key frictions.1)
Fictions between the mortgagor and the originator: predatory lending [2.1.1]
Subprime borrowers can be financially unsophisticated
Resolution: federal, state, and local laws prohibiting certain lending practices, aswell as the recent regulatory guidance on subprime lending2)
Frictions between the originator and the arranger: Predatory borrowing and lending[2.1.2]
The originator has an information advantage over the arranger with regard to thequality of the borrower.
Resolution: due diligence of the arranger. Also the originator typically makes anumber of representations and warranties (R&W) about the borrower and theunderwriting process. When these are violated, the originator generally mustrepurchase the problem loans.3)
Frictions between the arranger and third-parties: Adverse selection [2.1.3]
The arranger has more information about the quality of the mortgage loans whichcreates an adverse selection problem: the arranger can securitize bad loans (thelemons) and keep the good ones. This third friction in the securitization of subprime loans affects the relationship that the arranger has with the warehouselender, the credit rating agency (CRA), and the asset manager.
Resolution: haircuts on the collateral imposed by the warehouse lender. Duediligence conducted by the portfolio manager on the arranger and originator. CRAshave access to some private information; they have a franchise value to protect.4)
Frictions between the servicer and the mortgagor: Moral hazard [2.1.4]
In order to maintain the value of the underlying asset (the house), the mortgagor(borrower) has to pay insurance and taxes on and generally maintain the property.In the approach to and during delinquency, the mortgagor has little incentive to doall that.
Resolution: Require the mortgagor to regularly escrow funds for both insurance andproperty taxes. When the borrower fails to advance these funds, the servicer istypically required to make these payments on behalf of the investor. However,limited effort on the part of the mortgagor to maintain the property has noresolution, and creates incentives for quick foreclosure.5)
Frictions between the servicer and third-parties: Moral hazard [2.1.5]
The income of the servicer is increasing in the amount of time that the loan isserviced. Thus the servicer would prefer to keep the loan on its books for as long as
Leave a Comment