The Design of Mortgage-Backed Securities and Servicer Contracts

Abstract:     
We develop a unified model of mortgage and servicer contracts to analyze mortgage-backed security (MBS) design. We show that renegotiating mortgage contracts following default is strictly Pareto improving, if the lender gathers updated borrower information. To align servicer incentives with investor interests, we demonstrate that servicers must hold risk positions in MBS's that include "vertical'' components. While diversification of MBS pools enhances the ability to offer servicers incentive-compatible contracts, offering such contracts is not possible if foreclosure is highly inefficient and servicers do not sufficiently value investment in MBS's. In this case, MBS's should be nondiversified to preserve pool-wide information.

Number of Pages in PDF File: 51

Keywords: security design, mortgage contracts, renegotiation

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