This dissertation considers problems of adverse selection and moral hazard in secondary mortgage markets. Chapters 2 and 3 consider moral hazard and adverse selection respectively. While Chapter 4 investigates the predictions of the model presented in Chapter 2 using data from the commercial mortgage backed securities market.
Chapter 2 derives the optimal design of mortgage backed securities (MBS) in a dynamic setting with moral hazard. A mortgage underwriter with limited liability can engage in costly effort to screen for low risk borrowers and can sell loans to a secondary market. Secondary market investors cannot observe the effort of the mortgage underwriter, but they can make their payments to the underwriter conditional on the mortgage defaults. The optimal contract between the underwriter and the investors involves a single payment to the underwriter after a waiting period. Unlike static models that focus on underwriter retention as a means of providing incentives, the model shows that the timing of payments to the underwriter is the key incentive mechanism. Moreover, the maturity of the optimal contract can be short even though the mortgages are long-lived. The model also gives a new reason for mortgage pooling: selling pooled mortgages is more efficient than selling mortgages individually because pooling allows investors to learn about underwriter effort more quickly, an information enhancement effect. The model also allows an evaluation of standard contracts and shows that the "first loss piece" is a very close approximation to the optimal contract.
Chapter 3 considers a repeated security issuance game with reputation concerns. Each period, an issuer can choose to securitize an asset and publicly report its quality. However, potential investors cannot directly observe the quality of the asset and a lemons problem ensues. The issuer can credibly signal the asset's quality by retaining a portion of the asset. Incomplete information about issuer type induces reputation concerns which provide credibility to the issuer's report of asset quality. A mixed strategy equilibrium obtains with the following 3 properties: (i) the issuer misreports asset quality at least part of the time, (ii) perceived asset quality is a U-shaped function of the issuer's reputation, and (iii) the issuer retains less of the asset when she has a higher reputation.
Chapter 4 documents empirical evidence that subordination levels for commercial mortgage backed securities (CMBS) depend on issuer reputation in a manner consistent with the model of Chapter 3. Specifically, issuer retention is negatively correlated with issuer reputation. New measures for both issuer reputation and retention are considered.
