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AbstractIn this paper, we provide an overview of the subprime mortgage securitization process and the seven key informational frictions that arise. We discuss the ways that market participants work to minimize these frictions and speculate on how this process broke down. We continue with a complete picture of the subprime borrower and the subprime loan, discussing both predatory borrowing and predatory lending. We present the key structural features of a typical subprime securitization, document how rating agencies assign credit ratings to mortgage-backed securities, and outline how these agencies monitor the performance of mortgage pools over time. i
Executive SummarySection numbers containing more detail are provided in [square] brackets.• Until very recently, the origination of mortgages and issuance of mortgage-backed securities (MBS) was dominated by loans to prime borrowers conforming to underwriting standards set by the Government Sponsored Agencies (GSEs) [2] − By 2006, non-agency origination of $1.480 trillion was more than 45% larger than agency origination, and non-agency issuance of $1.033 trillion was 14% larger than agency issuance of $905 billion.• The securitization process is subject to seven key frictions. The arranger has more information about the quality of the mortgage loans which creates an adverse selection problem: the arranger can securitize bad loans (the lemons) and keep the good ones. This third friction in the securitization of subprime loans affects the relationship that the arranger has with the warehouse lender, the credit rating agency (CRA), and the asset manager. Resolution: haircuts on the collateral imposed by the warehouse lender. Due diligence conducted by the portfolio manager on the arranger and originator. CRAs have access to some private information; they have a franchise value to protect. 4) Frictions between the servicer and the mortgagor: Moral hazard [2. 1.4] In order to maintain the value of the underlying asset (the house), the mortgagor (borrower) has to pay insurance and taxes on and generally maintain the property.In the approach to and during delinquency, the mortgagor has little incentive to do all that. Resolution: Require the mortgagor to regularly escrow funds for both insurance and property taxes. When the borrower fails to advance these funds, the servicer is typically required to make these payments on behalf of the investor. However, limited effort on ...