Adverse Selection in the Home Equity Line of Credit Market

Abstract

Securitization has been widely assigned blame for contributing to the recent mortgage market meltdown and ensuing financial crisis. In this paper, we employ the OCC Home Equity database to develop estimates of default and prepayment probabilities for home equity lines of credit originated during 2004-2008 and tracked through 2014. Results show that securitized home equity loans bear both higher default and prepayment risk compared to loans held in portfolio by lenders, consistent with adverse selection in the securitization process. Spreads on securitized home equity lines are higher, as well, consistent with a “lemons spread”. Results are robust across multiple specifications, including models that address the endogenous decision to securitize, and support adoption of the credit risk retention rule for asset-backed securities.

Keywords: Mortgage Default and Prepayment, Home Equity Lines of Credit, Securitization

JEL Classification: G21, G28