LO 36.2: Identify and describe key frictions in subprime mortgage securitization,

LO 36.2: Identify and describe key frictions in subprime mortgage securitization, and assess the relative contribution o f each factor to the subprime mortgage problems.
In general, when two parties do not have the same information (which is usually the case), a sub-optimal outcome results. The two broad classes of information problems we will discuss here are moral hazard and adverse selection. Moral hazard denotes the actions one party may take to the detriment of the other. A classic example is the shareholder-manager relationship where the managers may use their position for personal gain rather than for
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Topic 36 Cross Reference to GARP Assigned Reading – Ashcroft & Schuermann
the shareholders to whom they owe a fiduciary duty. On the other hand, adverse selection is when one party possesses important hidden information. For example, a persons driving ability is private knowledge and a potential buyer of auto insurance will have the incentive to represent themselves as good drivers even if they are not. Mechanisms are designed to minimize these information problems such as board oversight for the managers and examination of driving records for those seeking auto insurance.
There are seven frictions in the mortgage securitization process. Each friction is discussed as follows.
Friction 1: Mortgagor and originator. The typical subprime borrower is typically
financially unsophisticated. As a result, the borrower may not select the best borrowing alternative for themselves. In fact, the borrower may not even be aware of the financing options available. On the other hand, the lender may steer the borrower to products that are not suitable.
Friction 2: Originator and arranger. The arranger (issuer) purchases the loans from
the originators for the purpose of resale through securitized products. The arranger will perform due diligence but still operates at an information disadvantage to the originator. That is, the originator has superior knowledge about the borrower (adverse selection problem). In addition, the originator may falsify or stretch the bounds of the application resulting in larger than optimal lending (predatory lending or predatory borrowing as discussed in

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