Adverse Selection in Mortgage Securitization

Publisher Website
Google Scholar
Abstract
We investigate the lenders’ choice of loans to securitize and examine whether the loans they sell into the secondary mortgage market are riskier than the loans they retain in their portfolios. Using the LPS Applied Analytics dataset of mortgage loans originated between 2003 and 2006, we find strong evidence that banks sold low default risk loans into the secondary market and retained higher default risk loans on their portfolios. The result holds for subprime as well as prime loans, although the difference is smaller for subprime loans. In addition to default risk, we also compare the performance of securitized loans and portfolio loans with respect to prepayment risk. We find support for adverse selection with respect to prepayment risk; securitized loans had a 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. Our results also identify differences in the performance of the loans purchased by GSEs versus private issuers. Loans sold to private issuers have lower prepayment rates while relative default rates show variations across years. The results support the findings in Ambrose, LaCour-Little and Sanders (2005) and suggest that reputation concerns and regulatory capital requirements may outweigh incentives for adverse selection in the lenders’ decision to securitize.

This publication has 0 references indexed in Scilit: