The amplification effects of adverse selection in mortgage credit suply

Abstract

This paper studies how information frictions in the securitization market amplify the response of mortgage credit supply to house price shocks. We model securitization as an optimal contracting problem between investors and banks. Banks are better informed than investors about the quality of the mortgages they originate, leading to an adverse selection problem. Investors use the quantity sold as a screening device to induce banks to reveal truthful information. We find that adverse selection amplifies the response of a bank’s mortgage originations to house price shocks. The degree of amplification is also a function of the technological differences in managing portfolios between banks and investors. The model has implications for the design of policy interventions aimed at stabilizing liquidity in the securitization market and credit provision to households in the credit market.