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Private Mortgage Securitization and Loss Given Default
Abstract
Loan performance varies by default probability and loss given default (LGD). While the relationship between securitization and default probability has been studied intensively, the effect of securitization on LGD remains unexplored. Using a unique dataset containing over forty thousand mortgage liquidations, this paper studies the effect of private securitization on LGD. We document that securitized loans incur higher LGD than observably similar portfolio loans. The results indicate that the effect comes mainly from the difference in loan quality between securitized and portfolio loans. Securitized opaque mortgages incur more than 18% (in relative terms) higher loan losses than observably similar portfolio loans. In addition, a difference‐in‐difference analysis provides evidence that pre‐crisis securitization standards contributed to higher loan losses. This article is protected by copyright. All rights reserved
... An increased understanding of valuation and loss-given defaults can explain the differences in mortgage lending losses and one of the mechanisms behind the informational asymmetry between banks and investors. Such biases between banks and investors contribute to significant losses in securitized mortgage lending portfolios (Higgins et al., 2022). ...
We examine valuation bias, regulatory loan-to-value limits, and real estate price fluctuations using unique data from two Norwegian banks. We investigate whether automated valuation methods significantly affect foreclosure discounts. Banks using multiple valuation methods tend to report loan-to-value bias by selecting the most optimistic value, underestimating and underreporting risk in declining property markets. This risk increases near regulatory loan-to-value limits, and the findings are robust across homogenous and heterogeneous properties. We recommend reporting automated valuation estimates for all applicable properties and disclosing the percentage of valuations done with different methods to improve transparency and risk comparability between banks.
Using the Credit Risk Transfers (CRTs) issued by Fannie Mae and Freddie Mac, we study how, absent government intervention, mortgage markets would price hurricane risk. Currently, such risk is priced equally across locations even if it is location‐specific. We hand collect a novel and detailed database to exploit CRTs' heterogeneous exposure to Hurricanes Harvey and Irma. Using a diff‐in‐diff specification, we estimate the reaction of private investors to hurricane risk. We use the previous results to calibrate a model of mortgage lending. We simulate hurricane frequencies and mortgage default probabilities in each US county to derive the market price of mortgage credit risk, that is, the implied guarantee fees (g‐fees). Market‐implied g‐fees in counties most exposed to hurricanes would be 70% higher than inland counties.
Using a unique nationwide mortgage servicing dataset, this paper investigates the underreporting of second liens in portfolio mortgages and compares underreporting in portfolio versus privately securitized mortgages. Portfolio loans have more than 40% of the second liens underreported. Low documentation securitized loans have a 47% (in relative terms) lower misreporting rate than observably similar portfolio loans. The portfolio setting allows us to provide strong evidence that misreporting happens in the early stages of intermediation by lenders. The decreased occurrence of misreporting in sold loans subjected to more rigorous screening indicates the effectiveness of MBS issuers' screening, though its overall effect remains limited. Further, we show that the lender‐MBS issuer affiliation also plays a role in misreporting.
We evaluate the effects of the 2009 Home Affordable Modification Program (HAMP) that provided intermediaries with sizable financial incentives to renegotiate mortgages. HAMP increased intensity of renegotiations and prevented a substantial number of foreclosures but reached just one-third of its targeted indebted households. This shortfall was in large part due to low renegotiation intensity of a few large intermediaries and was driven by intermediary-specific factors. Exploiting regional variation in the intensity of program implementation by intermediaries suggests that the program was associated with a lower rate of foreclosures, consumer debt delinquencies, house price declines, and an increase in durable spending.
OFHEO Working Papers are preliminary products circulated to stimulate discussion and critical comment. The analysis and conclusions are those of the authors and do not imply concurrence by other staff of the Office of Federal Housing Enterprise Oversight or its Director. Single copies of the paper will be provided upon request. References to OFHEO Working Papers (other than acknowledgement by a writer that he or she has had access to such unpublished material) should be cleared with the author to protect the tentative character of these papers.
We use loan-level data from the New York City metropolitan area to examine the extent to which lenders attempted to prevent foreclosures with concessionary modifications during the Great Depression. We find no principal forgiveness in the sample and only a handful of concessionary mortgage modifications of other types. Far more mortgages terminated through foreclosure than received any sort of concessionary modification. The results indicate that there are significant impediments to renegotiation of residential mortgages beyond securitization. As such, less renegotiation seems unlikely to be a major cost of securitization of residential mortgages. The Author 2011. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oup.com., Oxford University Press.
We demonstrate that a rapid expansion in the supply of mortgages driven by disintermediation explains a large fraction of recent U.S. house price appreciation and subsequent mortgage defaults. We identify the effect of shifts in the supply of mortgage credit by exploiting within-county variation across zip codes that differed in latent demand for mortgages in the mid 1990s. From 2001 to 2005, high latent demand zip codes experienced large relative decreases in denial rates, increases in mortgages originated, and increases in house price appreciation, despite the fact that these zip codes experienced significantly negative relative income and employment growth over this time period. These patterns for high latent demand zip codes were driven by a sharp relative increase in the fraction of loans sold by originators shortly after origination, a process which we refer to as "disintermediation." The increase in disintermediation-driven mortgage supply to high latent demand zip codes from 2001 to 2005 led to subsequent large increases in mortgage defaults from 2005 to 2007. Our results suggest that moral hazard on behalf of originators selling mortgages is a main culprit for the U.S. mortgage default crisis.
Did securitization exacerbate the foreclosure crisis by altering mortgage servicing practices? I exploit the unanticipated freeze of private mortgage securitization in 2007 to provide new evidence that securitization increases foreclosure probability and decreases modification probability. These effects are economically large and persist over time even after implementation of the Home Affordable Modification Program (HAMP) in 2009. Using hand-collected data on the contractual terms of servicing agreements, I show that servicers typically have broad discretion to modify loans but face significant incentives favoring foreclosure. The evidence implies that securitization significantly increased foreclosure rates during and after the crisis.
We examine the role of borrower concerns about future credit availability in mitigating the effects of adverse selection and income misrepresentation in the mortgage market. We show that the majority of additional risk associated with “low-doc” mortgages originated prior to the Great Recession was due to adverse selection on the part of borrowers who could verify income but chose not to. We provide novel evidence that these borrowers were more likely to inflate or exaggerate their income. Our analysis suggests that recent regulatory changes that have essentially eliminated the low-doc loan product would result in credit rationing against self-employed borrowers.
This paper explores the consequences of the collapse of the private-label residential mortgage-backed securities market in 2007 on banks' originations of jumbo mortgages. We show that jumbo lending declined by more at banks that were more dependent on this market and were less well capitalized. In contrast, banks that had little dependence on this market and were well capitalized increased jumbo originations. These findings highlight how dependence on the secondary market may cause amplification of financial shocks, and the potential value of capital requirements that are higher during periods of economic growth in mitigating the amplification effects.
This paper develops and estimates an instrumental variables strategy for identifying the causal effect of securitization on the incidence of mortgage modification and foreclosure based on the early-payment default analysis performed by Piskorsi, Seru, and Vig (2010). Estimation results show that securitized mortgages are more likely to be modified and less likely to be foreclosed on by servicers. These results are consistent with the interpretation in Adelino et al. (2013) that low modification rates are not the result of contract frictions inherent in the mortgage securitization process.
We study the effects of securitization on renegotiation of distressed residential mortgages over the current financial crisis. Unlike prior studies, we employ unique data that directly observes lender renegotiation actions and covers more than 60% of US mortgage market. Exploiting within-servicer variation in this data, we find that bank-held loans are 26% to 36% more likely to be renegotiated than comparable securitized mortgages (4.2 to 5.7% in absolute terms). Also, modifications of bank-held loans are more efficient: conditional on a modification, bank-held loans have lower post-modification default rate by 9% (3.5% in absolute terms). Our findings support the view that frictions introduced by securitization create a significant challenge to effective renegotiation of residential loans.
We study conflicting incentives of the master and special servicers in handling troubled loans in a CMBS deal and how the frictions between the interests of the two servicers might be diminished if the master and special servicing rights are held by the same firm. We show that concentrating both servicing rights in one firm reduces the likelihood that a defaulted loan terminates in foreclosure.
This study presents an intriguing contrast of the ex ante and ex post relations between mortgage securitization and loan performance using a comprehensive dataset from a major national mortgage bank. 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.
We investigate whether homeowners respond strategically to news of mortgage modification programs by defaulting on their mortgages. We exploit plausibly exogenous variation in modification policy induced by U.S. state government lawsuits against Countrywide Financial Corporation, which agreed to offer modifications to seriously delinquent borrowers with mortgages throughout the country. Using a difference-in-difference framework, we find that Countrywide's relative delinquency rate increased more than ten percent per month immediately after the program's announcement. The borrowers whose estimated default rates increased the most in response to the program were those who appear to have been the least likely to default otherwise, including those with substantial liquidity available through credit cards and relatively low combined loan-to-value ratios. These results suggest that strategic behavior of borrowers should be an important consideration in designing mortgage modification programs.
Low-cost deposits and increased balance sheet liquidity raise banks' supply of illiquid loans more than loans easily sold or securitized. We exploit the inability of Fannie Mae and Freddie Mac to purchase jumbo mortgages to identify an exogenous change in liquidity. The volume of jumbo mortgage originations relative to nonjumbo originations increases with bank holdings of liquid assets and decreases with bank deposit costs. This result suggests that the increasing depth of the mortgage secondary market fostered by securitization has reduced the effect of lender's financial condition on credit supply.
We examine whether securitization impacts renegotiation decisions of loan servicers, focusing on their decision to foreclose a delinquent loan. Conditional on a loan becoming seriously delinquent, we find a significantly lower foreclosure rate associated with bank-held loans when compared to similar securitized loans: across various specifications and origination vintages, the foreclosure rate of delinquent bank-held loans is 3% to 7% lower in absolute terms (13% to 32% in relative terms). There is a substantial heterogeneity in these effects with large effects among borrowers with better credit quality and small effects among lower quality borrowers. A quasi-experiment that exploits a plausibly exogenous variation in securitization status of a delinquent loan confirms these results.
This paper studies loss given default using a large set of historical loan-level default and recovery data of high loan-to-value residential mortgages from several private mortgage insurance companies. We show that loss given default can largely be explained by various characteristics associated with the loan, the underlying property, and the default, foreclosure, and settlement process. We find that the current loan-to-value ratio is the single most important determinant. More importantly, mortgage loss severity in distressed housing markets is significantly higher than under normal housing market conditions. These findings have important policy implications for several key issues in Basel II implementation.
The dramatic increase in securitisation activity experienced in Europe in the years following the introduction of the euro has altered the liquidity, credit and maturity transformation role traditionally performed by banks. We claim that the changing role of credit intermediaries due to securitisation has also modified the effectiveness of the bank lending channel and banks’ ability to grant loans. We use a novel database of securitisation activity and a large sample of European banks and find that the use of securitisation shelters banks’ loan supply from the effects of monetary policy. Securitisation activity has also strengthened banks’ capacity to supply new loans. This capacity, however, depends on business cycle conditions and, notably, on banks’ risks positions. The recent credit crisis is instructive in this respect.
The housing crisis threatens to destroy hundreds of billions of dollars of value by causing homeowners with negative equity to walk away from their houses. We advocate a legal reform that would allow homeowners to reduce principal while giving mortgage holders an equity interest. Such a plan would give homeowners an incentive to keep or resell their homes, thus reducing the market value loss of homes while protecting the effective value of creditors' interests. Two further elements of the plan are that it uses prices based on the average house price in a particular ZIP code; and it is automated. © The Author 2009. Published by Oxford University Press on behalf of the American Law and Economics Association. All rights reserved. For permissions, please e-mail: [email protected]
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We examine the consequences of existing regulations on the quality of mortgage loans originations in the originate-to-distribute (OTD) market. The information asymmetries in the OTD market can lead to moral hazard problems on the part of lenders. We find, using a plausibly exogenous source of variation in the ease of securitization, that the quality of loan origination varies inversely with the amount of regulation: more regulated lenders originate loans of worse quality. We interpret this result as a possible evidence that the fragility of lightly regulated originators' capital structure can mitigate moral hazard. In addition, we find that incentives which require mortgage brokers to have [`]skin in the game' and stronger risk management departments inside the bank partially alleviate the moral hazard problem in this setting. Finally, having more lenders inside a mortgage pool is associated with higher quality loans, suggesting that sharper relative performance evaluation made possible by more competition among contributing lenders can also mitigate the moral hazard problem to some extent. Overall, our evidence suggests that market forces rather than regulation may have been more effective in mitigating moral hazard in the OTD market. The findings caution against policies that impose stricter lender regulations which fail to align lenders' incentives with the investors of mortgage-backed securities.
We document the fact that servicers have been reluctant to renegotiate mortgages since the foreclosure crisis started in 2007, having performed payment-reducing modifications on only about 3 percent of seriously delinquent loans. We show that this reluctance does not result from securitization: Servicers renegotiate similarly small fractions of loans that they hold in their portfolios. Our results are robust to different definitions of renegotiation, including the one most likely to be affected by securitization, and to different definitions of delinquency. Our results are strongest in subsamples in which unobserved heterogeneity between portfolio and securitized loans is likely to be small and in subprime loans. We use a theoretical model to show that redefault risk, the possibility that a borrower will still default despite costly renegotiation, and self-cure risk, the possibility that a seriously delinquent borrower will become current without renegotiation, make renegotiation unattractive to investors.
A central question surrounding the current subprime crisis is whether the securitization process reduced the incentives of
financial intermediaries to carefully screen borrowers. We examine this issue empirically using data on securitized subprime
mortgage loan contracts in the United States. We exploit a specific rule of thumb in the lending market to generate exogenous variation in the ease of securitization and compare the composition and performance
of lenders' portfolios around the ad hoc threshold. Conditional on being securitized, the portfolio with greater ease of securitization defaults by around 10%–25%
more than a similar risk profile group with a lesser ease of securitization. We conduct additional analyses to rule out differential
selection by market participants around the threshold and lenders employing an optimal screening cutoff unrelated to securitization
as alternative explanations. The results are confined to loans where intermediaries' screening effort may be relevant and
soft information about borrowers determines their creditworthiness. Our findings suggest that existing securitization practices
did adversely affect the screening incentives of subprime lenders.
This paper analyzes the effect of three major provisions of state foreclosure laws (procedure, redemption period, and provision for deficiency judgment) on loan losses as reflected in the claims paid by private mortgage insurers and the FHA. It also explores the significance of the incentive conflict between the lender and the insurer in terms of the presence or absence of a coinsurance relationship and the existence of a deficiency judgment. The results demonstrate that foreclosure laws have a significant effect on loan losses and that the existence of a deficiency judgment affects the incentive conflict between lender and insurer. Copyright 1990 by Ohio State University Press.
We consider the economic consequences of changing the foreclosure rules. By incorporating renegotiation into the analysis, we show that although renegotiation decreases the number of foreclosures, it can make the effects of foreclosure more significant. Even when foreclosure does not actually occur, a change in foreclosure rules changes the threat points of lender and borrower in any renegotiation and thus changes the effective interest rate that the lender receives. In the long run, stated interest rates on loans will adjust to compensate for any change in the effective interest rate. We also examine the impact of a change in foreclosure laws on the borrower's welfare. Copyright 1994 by Kluwer Academic Publishers
Banks can choose to keep loans on balance sheet as private debt or transform them into public debt via asset securitization. Securitization transfers credit and interest rate risk, increases liquidity, augments fee income, and improves capital ratios. Yet many lenders still retain a portion of their loans in portfolio. Do lenders exploit asymmetric information to sell riskier loans into the public markets or retain riskier loans in portfolio? If riskier loans are indeed retained in portfolio, is this motivated by regulatory capital incentives (regulatory capital arbitrage), or a concern for reputation? We examine these questions empirically and find that securitized mortgage loans have experienced lower ex-post defaults than those retained in portfolio, providing evidence consistent with either the capital arbitrage or reputation explanation for securitization.
Regime shift and the post‐crisis world of mortgage loss severities
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