Moral Hazard, Adverse Selection, and Mortgage Markets by Barney Paul Hartman-Glaser A dissertation submitted in partial satisfaction of the requirements for the degree of Doctor of Philosophy in Business Administration in the Graduate Division of the University of California, Berkeley Committee in charge: Professor Nancy Wallace, Co-chair Professor Alexei Tchistyi, Co-chair Professor Dmirty Livdan Professor Robert Anderson Spring 2011 Moral Hazard, Adverse Selection, and Mortgage Markets Copyright 2011 by Barney Paul Hartman-Glaser 1 Abstract Moral Hazard, Adverse Selection, and Mortgage Markets by Barney Paul Hartman-Glaser Doctor of Philosophy in Business Administration University of California, Berkeley Professor Nancy Wallace, Co-chair Professor Alexei Tchistyi, Co-chair This dissertation considers problems of adverse selection and moral hazard in secondary mortgage markets. Chapters 2 and 3 consider moral hazard and adverse selection respec- tively. 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. 2 Chapter 4 documents empirical evidence that subordination levels for commercial mort- gage 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 repu- tation. New measures for both issuer reputation and retention are considered. i To my father, Barney G. Glaser an inspirational scholar, and my wife, Tiffany M. Shih, my academic and emotional rock. ii Contents Acknowledgments iv 1 Introduction 1 2 Optimal securitization with moral hazard 3 2.1 The Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 2.1.1 Preferences, Technology, and Information . . . . . . . . . . . . . . . . 7 2.1.2 Optimal Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 2.1.3 Solution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 2.1.4 The benefits of pooling . . . . . . . . . . . . . . . . . . . . . . . . . . 14 2.2 Standard contracts and the approximate optimality of the “first loss piece” . 15 2.2.1 The optimal contract versus a fraction of the mortgage pool . . . . . 15 2.2.2 The optimal contract versus a “first loss piece” . . . . . . . . . . . . 18 2.3 Extensions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 2.3.1 An Initial Capital Constraint . . . . . . . . . . . . . . . . . . . . . . 19 2.3.2 Maturity of the optimal contract . . . . . . . . . . . . . . . . . . . . 21 2.3.3 Partial Effort . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 2.3.4 Adverse selection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 2.4 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 3 Reputation and signaling in asset sales 28 3.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28 3.2 The model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 3.2.1 Assets, agents and actions . . . . . . . . . . . . . . . . . . . . . . . . 32 3.2.2 Issuer type, reputation and strategies . . . . . . . . . . . . . . . . . . 33 3.2.3 Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35 3.3 Solution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35 3.3.1 The game without reputation . . . . . . . . . . . . . . . . . . . . . . 35 3.3.2 Reputation dynamics and optimization . . . . . . . . . . . . . . . . . 38 3.3.3 Separating equilibria . . . . . . . . . . . . . . . . . . . . . . . . . . . 39 3.3.4 Mixed strategy equilibria . . . . . . . . . . . . . . . . . . . . . . . . . 42 3.3.5 Analysis of the mixed strategy equilibrium . . . . . . . . . . . . . . . 48 Contents iii 3.4 Extensions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54 3.4.1 Binary signal space . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54 3.4.2 Risky assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57 3.4.3 Path dependent beliefs . . . . . . . . . . . . . . . . . . . . . . . . . . 59 3.5 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61 4 CMBS issuer reputation and retention 63 4.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63 4.2 Instituational Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64 4.3 Data and Measurement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65 4.4 Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70 4.5 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71 Bibliography 75 A Proofs for Chapter Two 78 B Proofs for Chapter Three 86 iv Acknowledgments FirstIwishtothankallthefacultywhohaveplayedaroleinproducingthisdissertation, without their continued support and mentorship this process would have been impossible. In particular, special thanks are due to my co-chairs Nancy Wallace and Alexei Tchistyi. I thank Nancy for her perpetual willingness to listen to my ideas and help me improve them. I thank Alexei for arriving at the exact right moment and tirelessly helping me develop my skills as a theorist. Dmitry Livdan also deserves thanks on that front, as well as for helping me prepare for the job market. Other faculty whose support deserves special mention are Robert Anderson, Willie Fuchs, Robert Helsley, Dwight Jaffee, Atif Mian, Christine Parlour, Tomasz Piskorski, Jacob Sagi, and Steve Tedalis. Finally, Darrell Duffie deserves special thanks for early inspiration and support on the job market; without taking his course in dynamic asset pricing theory, I would not have considered a Ph.D. in finance. Next, I wish to thank those fellow graduate students who greatly influenced my devel- opment as a scholar. My cohort of Javed Ahmed, Bradyn Breon-Drish, Andres Donangelo, and Nishanth Rajan were particularly helpful in navigating the mine field that is getting a Ph.D. I learned so much from all of them. Andres was a great help as I prepared for the job market by helping me achieve the right balance of stress and excitement about the whole process. Sebastian Gryglewicz has influenced my thinking perhaps most of all, and has constantly been available to discuss ideas. Finally, my family deserves my grateful acknowledgment. My parents, Barney and Carolyn Glaser, and Gaylord and Susan Fukumoto have always encouraged and supported me, even when I was a difficult adolescent (between the ages of 14 and 29). My father, Barney, has instilled in me a love of learning and scholarship that will always be central to my life. This is perhaps the greatest gift a father can bestow upon his son. And last but not least, my wife Tiffany Shih deserves the most thanks of all. She did more than I thought was possible to help me finish this dissertation, including but not limited to proof reading multiple drafts, providing constructive conceptual comments, walking the dog when I was away/too tired, listening to my fears and self doubts, cooking my favorite meals, and this list goes on. 1 Chapter 1 Introduction Financial economists have worried about problems of asymmetric information, such as moral hazard (MH) and adverse selection (AS), in financial markets for decades. Recent events, like the subprime default crisis, seem to indicate that these problems are particularly pronounced in mortgage markets. At the same time, mortgage markets have a structure that poses new challenges for the both the theoretical and empirical literatures dealing with MH and AS. Moreover, mortgage markets are some of the largest financial markets in existence and are essential to the efficiency of the real economy. Thus, a deeper understanding of the specific manifestations and implications of MH and AS for mortgage markets is in order. In the following chapters I will consider 2 important examples of how these issues may be intrinsically different from those considered in the past literature. I will also present new empirical evidence from the CMBS market. In Chapter 2, I consider the problem of providing incentives to a mortgage underwriter, in which effort has long term consequences and must be exerted over many tasks at once.1 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 can- not 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 incen- tive 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: sell- ing 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. 1Chapter 2 draws on the co-authored article “Optimal Securitization with Moral Hazard” with Alexei Tchistyi and Tomazs Piskorski. At the time of submission of this dissertation, the article had not been published. Chapter 1. Introduction 2 In Chapter 3, I consider an adverse selection problem faced by investors when an issuer can both signal her private information through partial retention and build a reputation for honest reporting. The model can be characterized as a repeated security issuance game with reputation concerns. Each period, an issuer can choose to securitize an asset and publicly reportitsquality. However,potentialinvestorscannotdirectlyobservethequalityoftheasset 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 mort- gage 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 repu- tation. New measures for both issuer reputation and retention are considered. Note that in Chapter 2, I use the pronoun “we” to indicate that the work was done by multiple people whereas in Chapter 3 I used the pronoun “I,” as that work is entirely my own. Also note that although some symbols are present in both Chapters 2 and 3, their meaning may differ across chapters.