Interface 2003

Some Loans are More Equal than Others: Third-party Originations and Defaults in the Subprime Mortgage Industry
Scott D. Grimshaw, (Brigham Young University),,
Grant R. McQueen, (Brigham Young University Marriott School of Management),,
William P. Alexander, (Wachovia Securities),, and
Barrett A. Slade, (Brigham Young University Marriott School of Management),


We show how agency problems between lenders (principals) and third-party originators (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 not completely held accountable for the subsequent performance of those loans. Using a competing risks hazard model with 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 1 January 1996 and 31 December 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.

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