The amplification effects of adverse selection in mortgage credit supply

Abstract

This paper studies how information frictions in the securitization market amplify the response of mortgage credit supply to house price shocks. Securitization prices and quantities endogenously result from an optimal contracting problem between investors and banks. Banks are better informed than investors about the quality of mortgages they originate, leading to adverse selection in securitization. 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 credit 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 is informative on how information frictions can induce large fluctuations in mortgage credit supply.