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Adverse Selection in Mortgage Securization

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Document pages: 54 pages

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.

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