Wednesday, March 11, 2015 | 2:00pm–3:30pm | Room 335, HSBC Business School Building

Abstract

How does securitisation distort foreclosure decision of non-performing mortgages? Why mortgage servicers, who decide to foreclose or modify delinquent mortgages, seem to be given biased incentives? To address these questions, we develop a model to jointly study the security design problem of a mortgage pool owner (a bank), and the subsequent decision to foreclose or modify some mortgages which turn out to be non-performing. Anticipating the need to retain junior securities at the securitisation stage to signal its private information to the buyers, the bank optimally commits to an ex-post inefficient foreclosure policy, in order to reduce the signaling cost. Specifically, we show that securitisation under asymmetric information causes excessive (insufficient) foreclosures in a bad (good) state. When the bank hires a third-party mortgage servicer to implement the desired foreclosure policy, the servicer’s incentives will be endogenously biased. Our model generates novel predictions regarding foreclosure rate and mortgage servicers’ contract that are consistent with various empirical findings about the subprime mortgage crisis in the United States.