Optimal Securitization with Moral Hazard

Download or read book Optimal Securitization with Moral Hazard written by Barney Hartman-Glaser and published by . This book was released on 2011 with total page 46 pages. Available in PDF, EPUB and Kindle. Book excerpt: This paper considers the optimal design of mortgage backed securities (MBS) in a dynamic setting with moral hazard. A mortgage underwriter with limited liability can engage in costly effort to screen for low risk borrowers and can sell loans to a secondary market. Secondary market investors cannot observe the effort of the mortgage underwriter, but they can make their payments to the underwriter conditional on the mortgage defaults. We find the optimal contract between the underwriter and the investors involves a single payment to the underwriter after a waiting period. The dynamic setting of our model admits three new findings. First, unlike static models that focus on underwriter retention as a means of providing incentives, our model shows that the timing of payments to the underwriter is the key incentive mechanism. Second, the maturity of the optimal contract can be short even though the mortgages are long-lived. Third, selling pooled mortgages is more efficient than selling mortgages individually because pooling allows investors to learn about the underwriter's effort more quickly, an information enhancement effect. Our model also allows an evaluation of standard contracts and shows that the ldquo;first loss piecerdquo; is a very close approximation to the optimal contract.