In February 2011 the Wall Street Journal published an article about a disagreement among rating firms over the rating of a particular mortgage-backed security (MBS). The stated concern was that the MBS was not sufficiently diversified. An employee of Moody’s is quoted as saying: “Given this geographical concentration, there is ... idiosyncratic risk.” We contend that this is the wrong approach to securitization of mortgages that exhibit significant default risk. A basic result of portfolio theory is that investors can achieve diversification and elimination of idiosyncratic risk on their own by investing in a portfolio of securities. Our analysis in this paper goes further to argue that there may be a distinct disadvantage to diversification in mortgage backed securities, a “diversification discount”.
There are two incomplete contracting problems in the design of MBS’s: between the original borrowers and investors, and between servicers and investors. The first of these problems is present regardless of whether a loan is securitized. Securitization creates the second problem. In this paper we analyze the joint problems of the design of mortgage backed securities, the servicer contracts and the mortgage contracts.
Our main results follow from a few key assumptions about the nature of mortgages and mortgage-backed securities. We assume that: i) foreclosure is inefficient; ii) at the time that borrowers make their default decisions they have information about their collateral value that is available to the lender only at a cost; iii) investors in MBS’s cannot observe all of a servicer’s actions and servicers are wealth constrained. The first two assumptions suggest a contracting problem between borrowers and lenders (investors) regardless of whether a loan is securitized.
The third assumption, however, suggests a contracting problem between servicers and investors. It constrains the ability to align servicer incentives with the interests of investors. We demonstrate that in order to efficiently address the multiple incomplete contracting problems that are inherent in securitization, the assets in any given pool should be as similar (returns as highly correlated) as possible. The only risks that should be diversified within the pool are individual risks.
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The Design of Mortgage-Backed Securities and Servicer Contracts
