The Importance of Originator-Servicer Affiliation

56 Pages·2016·0.43 MB·English

Asymmetric Information in Loan Renegotiation: The
Importance of Originator-Servicer Affiliation ∗
James N. Conklin† Moussa Diop‡ Walter D’Lima§
November 28, 2016
Abstract
We present evidence that affiliation between the debt renegotiator and the originator
represents a mechanism to reduce asymmetric information inherent in debt renegotiation.
We hypothesize that affiliation affords servicers lower-cost access to borrower information,
thusimprovingtheirabilitytoimplementefficientdebtrestructuring. Consistentwiththis,
we show that affiliation affects the likelihood, form, and effectiveness of modifications in
a large sample of delinquent securitized mortgages. In a significant departure from the
recent literature, we show that the additional information available through affiliation is
“hard” in nature. As banks disintegrate origination and servicing, information critical for
debt renegotiation will be lost.
JEL Classifications: G21, R2, R3
Keywords: Information Asymmetry, Mortgage Default, Debt Renegotiation, Servicing,
Securitization, Mortgage Redefault, Non-agency MBS
∗We thank Itzak Ben-David, Scott Frame, Benjamin J. Keys, Michael LaCour-Little, Adam Levitin, Erwan
Quintin, Abdullah Yavas, and participants at the American Real Estate and Urban Economics Association
National meeting for helpful comments. We also thank Dennis McWeeny for outstanding research assistance.
All errors and omissions are our own. Funding support for the data used in this study was from University of
Wisconsin-Madison Graduate School.
†Terry School of Business, University of Georgia, Email: [email protected]
‡Wisconsin School of Business, University of Wisconsin-Madison, Email: [email protected].
§Mendoza College of Business, University of Notre Dame, Email: [email protected].
1 Introduction
Evidenceismountingthatinformationalproblemsinmortgagemarketsplayedasignificant
role in the financial crisis of 2007 to 2008. Much of the academic research has focused on the
rise of securitization and its effect on information production and use in loan origination
(Mian and Sufi (2009), Keys et al. (2009), Keys et al. (2010), Purnanandam (2011), Keys
et al. (2012), and Demiroglu and James (2012)). In contrast, relatively little research has
focused on asymmetric information in mortgage servicing. Because mortgage servicers are
responsible for loss mitigation efforts on delinquent loans (including debt renegotiation1 and
foreclosure), servicers play a crucial role in mortgage markets during economic downturns.
But servicers’ debt renegotiation efforts are plagued by asymmetric information: borrowers
have an informational advantage over servicers regarding their prospects of repayment. The
mechanismsavailabletoreducethisasymmetricinformationprobleminmortgagerenegotiation
are not well understood. We attempt to fill this gap in the literature.
In the traditional model of vertically integrated lending, the mortgage originator and the
servicer are the same entity. However, in the securitization model of lending, there may be
no link between the servicer and the originator. In this paper we argue that severing the link
between the originator and the servicer – a common practice in securitization – reduces the
information available to the mortgage servicer, consequently impairing its ability to evaluate
and implement effective debt renegotiation strategies. In other words, affiliation between
the servicer and the originator acts as a mechanism to reduce the asymmetric information
inherentindebtrenegotiation. Incontrasttorecentpapersthatstresstheimportanceof“soft-
information” collection (or lack thereof) by originators (Keys et al. (2010), Keys et al. (2009),
Purnanandam(2011), DemirogluandJames(2012), andRajanetal.(2015)), the“information
hypothesis” that we discuss in Section 3 argues that “hard” information collected by the
originator is relevant to loss mitigation, and that this information is more easily transmitted
to and used by affiliated servicers.
1Debt renegotiation is typically called loan modification in mortgage markets. We will use these two terms
interchangeably throughout this paper.
1
To test the information hypothesis, we first examine whether servicer-originator affiliation
affects the likelihood of debt renegotiation. Using a large sample of non-agency securitized
mortgage loans,2 we find that servicer-originator affiliated loans are 16% more likely to be
modified (relative to the mean) after controlling for contract and borrower characteristics,
house price changes, general economic conditions, and servicer fixed effects. The rich set of
control variables included in our regressions reduces concerns of omitted variable bias, and
the inclusion of servicer fixed effects exploits within servicer variation in modification rates
between affiliated and non-affiliated loans.
To assuage concerns that endogeneity of servicer-originator affiliation is biasing our results,
we estimate a 2SLS model and a bivariate probit model. For each loan in our sample, we con-
struct an instrument that measures the originator’s share of mortgages serviced by affiliated
entities over the three months prior to that mortgage’s origination month. If a large share of
the originator’s loans over the past few months have been sent to affiliated servicers, there is
a high probability that the next loan originated will also go to an affiliated servicer. However,
the share of the originator’s business that went to an affiliated entity before origination should
not directly impact the servicer’s subsequent modification decision on an individual loan. Our
results remain unchanged after instrumenting for affiliation: servicer-originator affiliation is
positively related to the probability that a seriously delinquent loan is modified. This rela-
tionship also holds in a robustness check using propensity score matching to control for the
possibility of selection on observables.
Afterdemonstratingthatservicer-originatoraffiliationaffectsthelikelihoodofdebtrenego-
tiation,weturntowhetherdifferentialaccesstoinformationforaffiliatedservicersexplainsthis
result. If affiliated servicers have lower cost access to information relevant to the modification
decision,thenthisinformationshouldaffectboththetypeofmodificationofferedandtheeffec-
tiveness of the modification. Our empirical results confirm that modification type varies with
servicer-originator affiliation. More importantly, mortgages modified by affiliated servicers are
2Focusing only on securitized loans ensures that the cash flow rights of the mortgages are sold to mortgage
backed security (MBS) investors regardless of whether the originator and the servicer are affiliated entities.
Thus,anyprincipal-agentissuesbetweentheMBSinvestors(theprincipal)andtheservicers(theagent)should
be independent of originator-servicer affiliation.
2
lesslikelytoredefaultaftermodification. Thus, byreducinginformationasymmetry, affiliation
allows the servicer to renegotiate mortgages more efficiently.
The mortgage servicing industry experienced considerable consolidation in 2008. We ex-
ploit variation in servicer and originator fates to provide further support for the information
hypothesis. We also consider whether affiliation with another intermediary (the MBS deal
sponsor) explains our result. The deal sponsor purchases originated loans and pools them
for securitization. The sponsor may be an unrelated party, or it may be affiliated to the
originator, the servicer, or both entities. Recent evidence suggests that sponsors may be
more likely to obtain private information when loans are originated by an affiliated entity
(Demiroglu and James (2012) and Adelino et al. (2014)). Critical to our information hypothe-
ses is the idea that servicers have lower-cost access to information on borrowers when the
information collector (the originator) is an affiliated entity. Thus, the information hypothesis
predicts that originator-servicer affiliation, rather than originator-sponsor or sponsor-servicer
affiliation, should be related to debt renegotiation. Consistent with this prediction, we find
that neither originator-sponsor nor servicer-sponsor affiliation is significantly related to the
likelihood of mortgage modification after controlling for servicer-originator affiliation. More
importantly, servicer-originator affiliation remains positively related to mortgage modification
after controlling for the other types of affiliation, suggesting that private information is more
likely to be acquired by the servicer when the collector of loan information (the originator) is
an affiliated entity.
The availability of total debt-to-income (DTI) ratio of borrowers at origination provides
further support that affiliated servicers have more information (or lower cost access to infor-
mation) on borrowers than unaffiliated servicers. There is a huge difference in the proportion
of affiliated loans that have this information (59%) relative to loans serviced by unaffiliated
entities (2%). This differential access to information is not due to missing DTI on low- and
no-docloanssincetheshareoflow-andno-docloansissimilaracrossaffiliatedandunaffiliated
servicers. Without conditioning on servicer-originator affiliation, access to DTI information
increases the likelihood of mortgage modification. However, when we control for originator-
servicer affiliation, availability of DTI information is no longer significantly related to the
3
probability of modification. This suggests that DTI provides some of the information trans-
mitted through affiliation.
Finally, we investigate whether the informational advantage of affiliated servicers is a re-
sult of “hard” or “soft” information. There is a large “distance” between the information
collector (the originator) and the servicer, both in terms of time and organizational form: the
debt renegotiation decision often occurs months or years after origination, and even when the
servicer is affiliated with the originator, servicing is handled in a separate department from
where origination takes place. The large distance between the information collector and the
servicer suggests that soft information is not likely to be transferred between them (Agarwal
and Hauswald (2010) and Petersen (2004)). To provide empirical support of this assertion,
we examine whether the effect of affiliation on modification varies across low- and full-income
documentation mortgages. A common empirical strategy used in the recent mortgage litera-
ture consists of demonstrating that a significant relationship is confined to low-doc loans, then
arguing that soft-information drives the results because soft information is more important on
low-doc loans (Keys et al. (2010), Keys et al. (2012), and Demiroglu and James (2012)). In
our study, the positive relationship between servicer-originator affiliation and the likelihood of
modification is important for both low- and full-doc loans. Since our result is not confined to
low-doc loans, this strengthens our argument that hard information relevant to debt renego-
tiation is more easily transmitted between the originator and an affiliated servicer. The fact
that DTI information –clearly a piece of hard information – is so much more readily available
to affiliated servicers also supports our conclusion.
Apotentialalternativeexplanationforourresultsisthatloanqualitydrivestherelationship
between servicer-originator affiliation and debt renegotiation. Demiroglu and James (2012)
arguethatoriginatorsscreenmoreintensivelyonloanswherethesponsorortheservicerislikely
to be an affiliated entity. Thus, affiliated loans are of higher average quality along dimensions
unobservable to the econometrician, and may represent better candidates for modification.
There are several reasons we believe this is not a major concern for our study. First, since we
focus only on delinquent mortgages, our analysis is based on loans that are revealed to be low-
qualityex post. Furthermore,ourfindingobtainswhenwerestrictoursampletoseverely(150+
4
days) delinquent loans, the lowest quality loans ex post. Most importantly, Demiroglu and
James (2012) argue that affiliation between the originator and the deal sponsor proxies for the
quality of a loan, and that the market is aware of the relationship between originator-sponsor
affiliation and loan quality. If unobserved loan quality is driving our results, and the market
is aware of this quality, then we would expect both originator-servicer and originator-sponsor
affiliation to be related to loss mitigation. However, we find that only originator-servicer
affiliation is significantly related to debt renegotiation.
This paper adds to the broad literature on asymmetric information in debt renegotiation
discussed in Section 2. Our results imply that vertical integration between the original lender
and the party responsible for the debt renegotiation decision alleviates asymmetric informa-
tion problems in debt restructuring. We also add to the literature examining asymmetric
information in mortgage markets and its role in the recent financial crisis. Although several
papers examine informational problems related to securitization and origination (Mian and
Sufi (2009), Keys et al. (2009), Keys et al. (2010), Purnanandam (2011), Keys et al. (2012),
and Demiroglu and James (2012))), relatively little research has examined asymmetric infor-
mation and its impact on debt renegotiation.3 Our results show that affiliation between the
servicer and the information collector (the originator) reduces asymmetric information that
prevents efficient mortgage modifications.
Our paper has important policy implications as well. High levels of mortgage defaults
combined with low rates of mortgage modifications prompted regulatory changes in the wake
of the recent mortgage crisis. Several regulatory changes, including the Secure and Fair En-
forcement for Mortgage Licensing Act of 2008 (SAFE Act) and the “Ability to Repay” rule,
target lax screening in the loan origination/underwriting process. Although these policies may
increase information collection in loan screening, they do not address the asymmetric informa-
tion problem in debt renegotiation examined in this paper. Also, many of the large vertically
integrated banks that traditionally handled origination and mortgage servicing have curtailed
these activities in recent years, at least in part due to higher compliance and regulatory capital
costs relative to non-banks (Karan and Goodman (2016)). The results in our paper suggest
3Adelino et al. (2013) and Mayer et al. (2014) are notable exceptions.
5
that this could heighten asymmetric information problems that may constrain mortgage debt
restructuring in the future.
2 Asymmetric Information and Debt Renegotiation
Information asymmetry about borrower risk is an important consideration in lending and
debtrenegotiation(Giammarino(1989)). AsLelandandPyle(1977)note: “[b]orrowerscannot
be expected to be entirely straightforward about their characteristics, nor entrepreneurs about
their projects, since there may be substantial rewards for exaggerating positive qualities.”
Lenders attempt to mitigate this information asymmetry through costly production of infor-
mation pertaining to the borrower’s prospects of repayment prior to extending credit (Sharpe
(1990)). Lenders also gather information from ongoing lending relationships to monitor ex-
isting loans and to determine whether to provide additional financing to the debtor (Fama
(1985)). Moreover, the information collected by the lender can reduce asymmetric information
in the event of debt renegotiation.4 As far as firm financing is concerned, Haugen and Senbet
(1978) argue that as long as it is costly for creditors to collect payments on a defaulted debt,
they should offer to reduce or modify the debt claim to avoid the large costs associated with
bankruptcy (Haugen and Senbet (1978) and Wruck (1990)). However, assuming the managers
of the firm are better informed than the debt holders about the value of the firm’s assets, it
will be difficult for debt and equity holders to agree on a workout when the firm is in distress
(Giammarino (1989) and Wang et al. (2002)). Consequently, any factors likely to reduce in-
formation asymmetry between managers and debt holders about the value of the firm should
increase the probability of successful debt renegotiation in the event of default.
Chan et al. (1986) further add that the ability of banks to benefit from existing lending
relationshipsdependson“thereusabilityofborrower-specificinformation.”5 Theadditionalin-
formationprovidedthroughtheongoingrelationshipgivesthebankaninformationaladvantage
relative to competing banks in the provision of additional financing to the existing customer.
4Buildingclosertieswithlendersalsobenefitsborrowersbygivingthemaccesstomorefinancing(Petersenand
Rajan (1994)).
5AccordingtoChanetal.(1986),forinformationtobereusuableitmustbedurable,notfastdecaying,andthe
lendermustbeinapositiontocapitalizefromitlaterbymaintainingabusinessrelationshipwiththeborrower.
6
The accumulation of more borrower-specific information should also reduce asymmetric infor-
mation in future debt renegotiations. When the link between a lender and a borrower weakens
or is severed (e.g., through securitization or sale of the debt) the reusability of archived bor-
rower information diminishes according to Chan et al. (1986). Thus the new debt holder (or
its agent) faces the challenge of having to gather new information on the borrower unless the
information collected by the original lender can be easily accessed. According to this theory,
banks should be in a better informational position to renegotiate debts originated in-house
relative to loans purchased from other lenders.
OnemightarguethattheinformationasymmetryemphasizedbyGiammarino(1989)isless
severe in mortgage lending since both the debtor – the property owner – and the lender should
have similar information about the value of the collateral (Wang et al. (2002)).6 Furthermore,
the coordination problem raised by Gertner and Scharfstein (1991) is less acute since most real
estate loans involve one lender. According to this line of reasoning lenders should be more
likely to renegotiate mortgage loans relative to corporate debt. However, a distinction must
be drawn between commercial loans, whose repayment is generally tied the income generated
by the property, and residential mortgages, whose repayment depends on borrowers’ personal
income. Even though information asymmetry about the value of the collateral may not be a
major issue in real estate lending, lenders are at an informational disadvantage (relative to the
borrower) regarding the borrower’s prospects of repayment. Adelino et al. (2013) argue that
thistypeofinformationasymmetryhelpstoexplainlowlevelsofdebtrenegotiationobservedin
residentialmortgagemarkets.7 Inthispaperwearguethatinformationasymmetryregardinga
borrower’s prospects of repayment is mitigated on securitized loans through affiliation between
the servicer and the information collector (the originator) and that this has implications for
debt restructuring.
6Boththelenderandtheborrowerrelyonindependentappraisalsofpropertyvaluesbasedonsimilarinformation
about the market, the attributes of the property and recent comparable sales.
7Inadditiontoinformationasymmetry,moralhazardisanimportantconsiderationaffectingalender’sdecision
about whether to modify a loan. Riddiough and Wyatt (1994) note that many mortgage lenders take a hard
line in dealing with defaults and are reluctant to renegotiate debt because of this moral hazard. Mayer et al.
(2014)provideempiricalevidencethatalaxmodificationpolicycaninduceborrowerstodefaultwhentheyhave
the ability to pay.
7
Mortgage debt restructuring has received considerable attention in recent years in the aca-
demic literature.8 Much of this research has focused on investigating frictions that potentially
prevent debt renegotiation even when it is (supposedly) in the best interests of both borrow-
ers and investors. Eggert (2007) discusses several of these frictions for securitized mortgages,
including agency issues related to the mortgage servicer,9 securitization contracts that limit
servicer discretion, and conflicting interests between investors in different tranches of securi-
tizations. Several papers argue that securitization itself prevents efficient debt renegotiation
(Piskorski et al. (2010), Agarwal et al. (2011), Kruger (2014), and Adelino et al. (2013)) and
some have specifically mentioned information asymmetry as a key hindrance to debt renegoti-
ation (Adelino et al. (2013)).
In this study we examine the relationship between servicers’ access to information about
borrowers and debt renegotiation that has largely been ignored in the existing literature. In
a parallel study, Le (2016) investigates the relationship between servicer-originator affiliation
and the effectiveness of mortgage modifications using a different data source for securitized
mortgages (Blackbox Logic). Consistent with our results, Le (2016) finds that redefault rates
aresignificantlyloweronaffiliatedloans. WhereasLe(2016)focusesprimarilyonthequalityof
the modification, we spend considerable time on the relationship between servicer-originator
affiliation and the likelihood of modification. The papers also differ in their emphasis on
the relevant type of information (e.g., hard or soft) and methods to control for endogeneity in
affiliation. Also,Le(2016)doesnotcontrolforothertypesofaffiliation(e.g.,originator-sponsor
andsponsor-servicer). Despitetheirdifferences, thepaperscanbeviewedascomplementaryin
thattheybothhighlighttheimportanceofserviceraccesstoinformationfordebtrenegotiation.
8LevitinandTwomey(2011)provideanoverviewoftheinstitutionaldetailsofthemortgageservicingindustry
and the economics of loss mitigation for securitized mortgages.
9Since servicers typically do not own the mortgage asset they control, a classic principal-agent problem exits.
Servicers generally act to maximize the value of their servicing asset, rather than the net present value of the
mortgage asset for investors. Misaligned incentives can lead servicers to foreclose when debt restructuring is
optimal,oralternatively,tomodifythemortgagewhenforeclosureisoptimal. LevitinandTwomey(2011)and
Thompson (2011) argue that servicers’ incentives are skewed towards foreclosure.
8
3 Information hypothesis of mortgage servicing
During the Great Recession much of the policy debate focused on mortgage modifications,
particularlyontheideathatfrictionsinthemortgagemarketpreventedmortgagemodifications
even when modifications were in the best interests of both borrowers and MBS investors.10
Adelino et al. (2013) refer to this as the “institutional theory” for low levels of modification.
Forexample,servicerincentivesmayfavorforeclosureasalossmitigationstrategy(Levitinand
Twomey (2011), Thompson (2011), Eggert (2007), Mayer et al. (2009), and Kruger (2014)).
Also,poolingandservicingagreements(PSA)thatlayoutthedutiesandresponsibilitiesofthe
mortgage servicer in a securitization may limit the number and types of modifications the deal
servicer may perform (Levitin and Twomey (2011), Eggert (2007), and Mayer et al. (2009)).
In addition to the institutional theory, recent evidence suggests that information asym-
metry also inhibits debt renegotiation. Adelino et al. (2013) argue that borrowers have an
informational advantage over servicers regarding their prospects of repayment, which can lead
to an inefficiently high level of renegotiations if servicers modify delinquent loans that would
haveself-curedontheirown. Additionally,servicersmayinefficientlydelayforeclosurebymod-
ifying loans that will redefault. Adelino et al. (2013) show that both self-cures on delinquent
mortgages and redefaults on modified loans are quite common, potentially explaining the ob-
served low levels of loan modifications. In addition, servicers need to consider the potential for
moral hazard. If it is costly or difficult to determine who truly needs a modification, a rela-
tively liberal modification policy by a servicer may induce borrowers to strategically default in
order to receive a mortgage modification. The potential for moral hazard is particularly acute
if the servicer is at an informational disadvantage with respect to the borrower’s prospects of
repayment. Takentogether, theresults ofAdelinoetal.(2013) andMayeret al.(2014)suggest
that information problems play a key role in the servicing of delinquent mortgages. This also
implies that the availability of additional information to servicers can reduce these problems
and affect servicers’ debt renegotiation strategies.
10Throughout the paper we will refer to investors in a MBS as one group. In reality, in each MBS deal there
are multiple tranches, and the the interests of investors in different tranches may not be aligned.
9