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Adverse Selection in Mortgage Securization

54 Pages Posted: 8 Jul 2010 Last revised: 17 Jun 2012

Sumit Agarwal

Georgetown University - Department of Finance

Yan Chang

Federal Home Loan Mortgage Corporation (FHLMC)

Abdullah Yavas

University of Wisconsin - School of Business - Department of Real Estate and Urban Land Economics

Date Written: June 1, 2010

Abstract

We investigate determinants of lenders’ choice to securitize loans, focusing on the quality of loans they sell to investors in the secondary mortgage market relative to ones they retain on their balance-sheets. Using several large datasets of mortgage loans originated between 2004 and 2007, we find that the impact of securitization on lender's choice differs significantly across markets. In the prime market, banks generally sold low-default-risk loans into the secondary market while retaining higher-default-risk loans in their portfolios. In contrast, these lenders retain loans with lower prepayment risk relative to loans they sold. We rationalize these findings by arguing that GSEs impose control on default-risk of loans originated by lenders since they offer guarantees only against default risk to investors. In contrast, the subprime market does not exhibit any clear pattern. Finally, securitization strategy of lenders securitizing in the prime market changed dramatically in 2007 as the crisis set in with most unwilling to retain higher-default-risk loans in return for lower prepayment risk.

Suggested Citation

Agarwal, Sumit and Chang, Yan and Yavas, Abdullah, Adverse Selection in Mortgage Securization (June 1, 2010). Paolo Baffi Centre Research Paper No. 2010-67. Available at SSRN: https://ssrn.com/abstract=1635749 or http://dx.doi.org/10.2139/ssrn.1635749

Sumit Agarwal

Georgetown University - Department of Finance ( email )

3700 O Street, NW
Washington, DC 20057
United States
202-687-8207 (Phone)

HOME PAGE: http://www.ushakrisna.com

Yan Chang (Contact Author)

Federal Home Loan Mortgage Corporation (FHLMC) ( email )

8200 Jones Branch Road
McLean, VA 22101
United States

Abdullah Yavas

University of Wisconsin - School of Business - Department of Real Estate and Urban Land Economics ( email )

School of Business
975 University Avenue
Madison, WI 53706
United States

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