Some Loans Are More Equal Than Others: Third-Party Originations and Defaults in the Subprime Mortgage Industry

Article excerpt

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 like ly 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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Near the end of George Orwell's classic, Animal Farm, when the pigs have usurped power and privilege in the former egalitarian workers' utopia, the Seventh Commandment of Animalism is changed from "All animals are equal" to "All animals are equal but some animals are more equal than others." Industry practice and academic research both suggest that mortgage defaults can be theoretically motivated and empirically modeled using two schools of thought: ability to pay and put-option value. The older ability-to-pay school views home ownership as a consumption good, and borrowers default when they can no longer make the payments. The newer, put-option-value school views home ownership as an investment where the mortgage contains a put option; the borrower defaults and puts the house to the lien holder when its value falls below the loan value. Both schools find empirical support for their models. (1) We add a third predictor of defaults, the principal--agent problems between lenders and third-party originators (TPO s) such as mortgage brokers. After controlling for the ability to pay and the value of the put option, we find that loans originated by TPOs are more likely to default than loans originated by the retail arm of the lending institution, suggesting that some loans are more equal than others. That is, the performance of TPO channel loans is differentially worse than retail loans. Whether this differential performance is due to self-selection, variation in variables that are not captured, or gaming the origination system is unknown.

Finding that some loans are more risky than others does not, by itself, imply a market inefficiency. Inefficiency exists only if loans with different risk receive similar interest rates. We document such an inefficiency. In the early years of our sample, the interest rate charge on TPO loans equaled the interest rate on retail loans even though, in hindsight, the TPO loans were more risky. Interestingly, as the subprime industry grew and matured, it also learned. Specifically, we show that after the initial short-lived inefficiency, lenders apparently learned that TPOs default at a greater rate than similar retail loans and began to price the default risk.

Our contributions can be best summarized as extending and merging two branches of the mortgage literature: the agency-cost branch and the default branch. In the first branch, LaCour-Little and Chun (1999) use the marginal incentives faced by TPOs to predict that TPO loans prepay faster than loans originated by retail arms of lending institutions. (2) Using 16,974 individual loans originated in 1992, they find evidence of agency problems, specifically "churning" on the part of TPOs whose loans prepaid at a faster rate than similar retail loans. …