Recently I attended a two-day symposium on mortgages and the future of housing finance on on October 25 and 26, 2010, hosted by the Federal Deposit Insurance Corporation (FDIC) and the Federal Reserve System. (Here’s the link to the agenda: www.fdic.gov/bank/analytical/cfr/oct2010-conf.html.)
There were three sessions that I personally found particularly interesting that I’ll be summarize over the next few days; (1) loss mitigation and loan modification practices and performance, (2) adverse selection in mortgage securitization, and (3) mortgage default decisions including strategic default. In this second post, I’ll focus on securitization adverse selection problems.
And actually, to be more accurate, the papers presented at this conference actually bring into question the idea that there is a residential mortgage securitization adverse selection problem. The first paper (that can be downloaded here) was presented by Ashlyn Nelson, concluded that:
While the paper supports that the bank applies lower screening efforts on loans that have higher ex ante probability of being securitized, it further shows that loans remaining on the bank’s balance sheet are, ex post, of worse quality than sold loans. Most of the differences can be explained away by secondary market investors’ information advantage over the originating bank due to the time lag between loan origination and loan sale. While many blame the presence of the secondary market for the emergence of “liars’ loans,” we find that ironically these loans hurt the originating bank more than it did the secondary market.
Yan Chang also presented a paper (available here) that came to a somewhat similar conclusion:
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.
In the discussion that followed, Laurie Goodman (of Amherst Securities) was rather critical of the Chang paper. First off, it used a dataset supplied by LPS Applied Analytics that under-represents subprime loans. She also thought that some of the more bizarre results could be because originators just couldn’t sell their higher-risk loans.
In any case, there’s some food for thought here, keeping in mind that previous searches for the “smoking gun” of adverse selection, and slack screening of securitized loans has been hard to come by. For every study that has seemingly found adverse selection evidence, there’s another that disputes in some way or another.
That’s all for the securitization sessions, and in the next post I’ll cover the strategic default-focused sessions.
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* John Kiff is a Senior Financial Sector Expert at the IMF. These are his personal views, and should not be attributed to the IMF, its Executive Board, or its management.
