Optimal Securitization with Moral Hazard

46 Pages Posted: 1 Apr 2009 Last revised: 20 Aug 2011

Barney Hartman-Glaser

University of California, Los Angeles (UCLA) - Anderson School of Management

Tomasz Piskorski

Columbia Business School - Finance and Economics

Alexei Tchistyi

University of Illinois at Urbana-Champaign - Department of Finance

Date Written: July 15, 2011

Abstract

This paper considers the optimal design of mortgage backed securities (MBS) in a dynamic setting with moral hazard. A mortgage underwriter with limited liability can engage in costly effort to screen for low risk borrowers and can sell loans to a secondary market. Secondary market investors cannot observe the effort of the mortgage underwriter, but they can make their payments to the underwriter conditional on the mortgage defaults. We find the optimal contract between the underwriter and the investors involves a single payment to the underwriter after a waiting period. The dynamic setting of our model admits three new findings. First, unlike static models that focus on underwriter retention as a means of providing incentives, our model shows that the timing of payments to the underwriter is the key incentive mechanism. Second, the maturity of the optimal contract can be short even though the mortgages are long-lived. Third, selling pooled mortgages is more efficient than selling mortgages individually because pooling allows investors to learn about the underwriter’s effort more quickly, an information enhancement effect. Our model also allows an evaluation of standard contracts and shows that the “first loss piece” is a very close approximation to the optimal contract.

Keywords: Security design, mortgage backed securities

JEL Classification: G20, G21, G32

Suggested Citation

Hartman-Glaser, Barney and Piskorski, Tomasz and Tchistyi, Alexei, Optimal Securitization with Moral Hazard (July 15, 2011). Available at SSRN: https://ssrn.com/abstract=1365000 or http://dx.doi.org/10.2139/ssrn.1365000

Barney Hartman-Glaser (Contact Author)

University of California, Los Angeles (UCLA) - Anderson School of Management ( email )

110 Westwood Plaza
Los Angeles, CA 90095-1481
United States

Tomasz Piskorski

Columbia Business School - Finance and Economics ( email )

3022 Broadway
New York, NY 10027
United States

Alexei Tchistyi

University of Illinois at Urbana-Champaign - Department of Finance ( email )

1206 South Sixth Street
Champaign, IL 61820
United States

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