Short Take

Clues to the Market When Mortgage Originators Delay Securitization

Investing in securitized home mortgages can be risky, as anyone caught holding subprime mortgage-backed instruments in 2008 can attest. The underlying value of the security is only as good as the individual mortgages that it comprises, and the true creditworthiness of each can be a mystery. The mortgage originator knows a lot more about the risk behind any individual loan than the aggregator that buys it, packages it and markets it to investors.

But mortgage originators do give off important hints about the quality of many of the loans they sell to this market, according to findings in the UCLA Ziman Center for Real Estate Working Papers series. When a mortgage originator decides to hold a loan rather than sell it for aggregation immediately, the likelihood of the loan's going into default within three years drops dramatically, report Duke University's Manuel Adelino, the Atlanta Fed's Kristopher Gerardi and UCLA Anderson's Barney Hartman-Glaser.

The paper concerns loans sold into the private market, not those sold to government-backed agencies. This private aggregation market gets the loans that don’t conform to conventional mortgage requirements, such as those lacking at least 20 percent of the price as down payment or certain documentation to prove ability to repay.

In this private market, the average default rate for loans sold five months or more after origination is 11 percent compared to a 16 percent default rate for the sample. (For this study, loans were considered in default if 60 days delinquent.)

About 80 percent of home mortgages purchased for private market securitization are sold to aggregators within a month of origination, Hartman-Glaser explains in an interview. To reduce risk and cost of carrying loans, mortgage originators sell most of their loans immediately, either to government-backed agencies or to aggregators in the private market. About 90 percent of all mortgages are sold in the first five months after origination.

The study finds the time held by the originator to be a better predictor of a loan's default and value potential than traditional data available to aggregators, including credit scores. The value of this "signaling" appears particularly high in the Alt-A market, where loans do not conform to government standards of conventional mortgages but are not necessarily riskier. The Alt-A category includes loans to individuals who are self-employed or have variable income that is difficult to forecast sufficiently for Fannie Mae or Freddie Mac. Many Alt-A loans are for second homes or investment properties.

Although most Alt-A loans are considered lacking in documentation, mortgage originators make them because they know more about the borrowers — such as their earnings prospects — than appears in the standard paperwork. A short hold before selling tells aggregators that the mortgage originator believes the loan is safe and, therefore, worth more in a sale, Hartman-Glaser explains.

The study reports that these more seasoned loans sell at lower yields (meaning at a higher price), indicating that buyers perceived them as less risky than loans available for purchase immediately after origination. One additional month's hold results in a 1.52-basis-point reduction in yield spread, the study states. Alt-A bonds sold at an average 28-basis-point spread to AAA-rated mortgage bonds. The spread on Alt-A bonds that were held for up to three months was 2.4 basis points lower, according to the study.

The researchers found no evidence that a hold on conventional loans offered investors any additional information about quality. Automated underwriting and credit guarantees in the conventional mortgage market standardize the information buyers receive and eliminates the need for additional information from the mortgage originator, the authors state.

Adelino, M., Gerardi, K., & Hartman-Glaser, B. (2017). Are lemons sold first? Dynamic signaling in the mortgage market. UCLA Ziman Center for Real Estate Working Papers.

Barney Hartman-Glaser

Assistant Professor of Finance

Barney Hartman-Glaser’s research applies contract and game theory to financial and real estate markets. He has conducted research on the consequences of private information in mortgage markets in which he showed that mortgage-backed securities issuers may cash in on their reputations by selling low-quality assets. He has also written on the incentives of mortgage originators to screen for good borrowers.

 

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