Friday, October 16, 2015

Servicing Securitisation through Inefficient Foreclosure

Read the working paper
INSEAD Working Paper 2015/81/FIN

How does securitisation distort foreclosure decision of non-performing mortgages? Why do mortgage servicers, who decide to foreclose or to renegotiate delinquent mortgages, seem to be given biased incentives? What role do they play in securitisation? To address these questions, we develop a model in which an impatient, informed mortgage pool owner (a bank) designs and sells a mortgage-backed security to uninformed investors, and chooses the servicing arrangement which affects the subsequent decision to foreclose or modify delinquent mortgages. By contracting with a third-party servicer, the bank is able to effectively commit to a foreclosure policy that optimally trades off the ex ante cost of securitisation under asymmetric information against the ex post cost of inefficient foreclosure. We show that securitisation leads to excessive (insufficient) foreclosures in a bad state if the mortgage pool is of low (high) quality. The servicer’s incentives are thus endogenously biased. Our model generates novel predictions regarding foreclosure rate and mortgage servicing contract that are consistent with various empirical findings about the subprime mortgage crisis in the United States.