Monday, July 26, 2010

Adverse Selection in Mortgage Securization

By Sumit Agarwal, Yan Chang and Abdullah Yavas

Abstract: We investigate lenders’ choice of loans to securitize and whether the loans they sell into the secondary mortgage market are riskier than the loans they retain in their portfolios. Using a large dataset of mortgage loans originated between 2004 and 2008, we find that banks sold low-default risk loans into the secondary market while keeping higher-default risk loans in their portfolios. This result holds for both subprime and prime loans. We do find strong support for adverse selection with respect to prepayment risk; securitized loans had higher prepayment risk than portfolio loans. It appears that in return for selling loans with lower default risk, lenders retain loans with lower prepayment risk. Small lenders place more emphasis than large lenders on default risk versus prepayment risk of the loans they retain. Securitization strategies of lenders changed during the sample period as they became less willing to retain higher-default loans after the housing market reached its peak. There are also differences in the performance of loans sold to GSEs and loans sold to private issuers. Loans sold to private issuers have lower prepayment rates in each year while relative default rates vary across the years.

Download here: papers.ssrn.com/sol3/papers.cfm?abstract_id=1635749

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