LO 36.8).

LO 36.8).
Friction 3: Arranger and third-parties. The arranger of the pool of mortgages will possess
better information about the borrower than third parties including rating agencies, asset managers, and warehouse lenders. The adverse selection problem gives the arranger the opportunity to retain the higher quality mortgages and securitize the lower quality mortgages (i.e., lemons).
The warehouse lender temporarily holds and finances the underlying purchases. As a precaution, the warehouse will fund less than 100% of its estimated collateral value forcing the arranger to retain a equity position on its balance sheet.
The asset portfolio manager purchases the assets for the pool from the arranger. Once again, the arranger has superior information about the creditworthiness of the mortgage pool. To minimize the potential adverse selection problem, the asset manager must use adequate due diligence, use reputable arrangers, and force credit enhancements from the arranger.
Similarly, the rating agencies determine the amount of credit enhancement necessary to achieve the desired credit rating. Thus, the rating agency is dependent on the information provided by the arranger. Typically, the due diligence on the arranger and originator is rushed.
Friction 4:
Servicer and mortgagor. The servicers role is to manage the cash flows of the pool and follow up on delinquencies and foreclosures. A conflict of interest arises for delinquent loans. The homeowner in financial difficulty does not have the incentive to upkeep tax payments, insurance, or maintenance on the
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property. Escrowed funds can minimize this problem but ultimately efficient foreclosure must comply with federal regulations.
Friction 5:
Servicer and third-parties. The servicer faces a moral hazard problem because their (lack of) effort can impact the asset manager and credit rating agencies without directly affecting their own cash flow distribution. In delinquency, the servicer is responsible for the property taxes and insurance premiums. These funds are reimbursable upon foreclosure so there is a temptation to exaggerate the fees and expenses particularly with high recovery rates.
The servicer also has an incentive to keep the problem loan on its books by modifying loan terms rather than foreclose (investor preference). Since most of the costs are unrecoverable (escrow analysis, payment set up, etc.) the property needs to be active to generate any additional funds to the servicer.
It is apparent that the quality of the servicer can directly impact the cash flows of the pool which in turn affects the credit rating. Changes in credit ratings reflect poorly on the agency. Therefore, the credit rating agencies must use due diligence in analyzing the servicer as well as the underlying collateral.
Friction 6:
Asset manager and investor. The investor relies on the asset managers expertise to identify and analyze potential investments. It is difficult for the investor to comprehend the investment strategy and the investor will not be able to observe the effort of the management team (same moral hazard problem as shareholder-manager). Investment mandates and proper benchmarking can mitigate some of the distortion.
Friction 7:
Investor and credit rating agencies. Rating agencies are compensated by the arranger and not the end user, the investor. To the extent that the rating agencies are beholden to the fee structure of the arranger, a conflict of interest arises. In addition, it is very difficult to judge the accuracy of their models particularly with complex products and rapid financial innovation.
Five of these factors are direct contributors to the recent subprime crisis. First, the complexity of the product and naive nature of the borrower led to inappropriate loans (friction 1). Second, managers sought the additional yield from structured mortgage products without fully assessing the associated risks (friction 6). Third, the problem became more expansive as underperforming managers made similar investments with less due diligence on the arranger and originator (friction 3). Fourth, as the asset managers reduced their oversight, it was natural that the arranger would follow suit (friction 2). This left the credit rating agencies as the last line of defense but they operated at a significant informational disadvantage. Finally, the assigned ratings were hopelessly misguided (friction 7).
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C h a r a c t e r i s t i c s o f t h e S u b p r i m e M o r t g a g e M a r k e t

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