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Some Loans Are More Equal than Others: Third–Party Originations and Defaults in the Subprime Mortgage Industry
Author(s) -
Alexander William P.,
Grimshaw Scott D.,
McQueen Grant R.,
Slade Barrett A.
Publication year - 2002
Publication title -
real estate economics
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.064
H-Index - 61
eISSN - 1540-6229
pISSN - 1080-8620
DOI - 10.1111/1540-6229.t01-1-00054
Subject(s) - default , basis point , economics , inefficiency , real estate , agency (philosophy) , interest rate , monetary economics , default risk , mortgage insurance , mortgage underwriting , incentive , secondary mortgage market , business , financial economics , credit risk , financial system , actuarial science , finance , market economy , insurance policy , philosophy , epistemology , casualty insurance
We show how agency problems between lenders (principals) and third–party originators (TPO; agents) imply that TPO–originated loans are more likely to default than similar retail–originated loans. The nature of the agency problem is that TPOs are compensated for writing loans, but are not completely held accountable for the subsequent performance of those loans. Using a hazard model with jointly estimated competing risks and unobserved heterogeneity, we find empirical support for the TPO/default prediction using individual fixed–rate subprime loans with first liens secured by residential real estate originated between January 1, 1996, and December 31, 1998. We find that apparently equal loans (similar ability to pay, option incentives and term) can have unequal default probabilities. We also find that, initially, the agency–cost risk was not priced. At first, the market did not recognize the higher channel risk, since TPO and retail loans received similar interest rates even though the TPO loans were more likely to default. We also show that this inefficiency was short–lived. As the difference in default rates became apparent, interest rates on TPO loans rose about 50 basis points above otherwise similar retail loans.