Adverse Selection in the Wholesale Mortgage Market

This paper studies the role of private information in determining the allocation of loans through the wholesale mortgage market. Mortgage originators who sell loans in the wholesale market are often approved to securitize their mortgages with the Government Sponsored Enterprises (GSEs) by selling through the cash window. Originators decide for each loan whether to (a) sell to third-party investors in the wholesale market, or (b) sell loans to the GSEs for a lower price while retaining future servicing rights and payments.

I explain the determinants of this choice by developing an intuitive model that builds on the framework of Chiappori and Selanié (2000), which can be deployed to study a variety of transactions involving two-sided private information. Originators make their decision based on a private signal about loan quality, any information conveyed by wholesale investors' price offers, and (possibly originator-specific) costs of servicing and securitization. I estimate the model on a novel linked dataset that includes GSE and investor price offers from a large loan trading platform.

My results suggest that originators possess private information relevant to a loan's future cash flows and that they leverage this private information when deciding between selling and securitizing. Furthermore, the price offers of wholesale investors are informative for originators, allowing them to refine their beliefs about loan quality and strategically allocate loans. Finally, originators differ widely in their costs of servicing and securitization.

I use the model estimates to study two market-design counterfactuals. First, when only coarse-grained loan attributes are priced (as in a posted-price market), the inability to price individual loans decreases the number of loans obtained by wholesale investors. Second, when forced to choose between exclusive use of wholesale or securitization channels, most originators choose to sell all originated loans on the wholesale market.

Together, these results suggest that the current structure of wholesale markets is valuable to originators in part because it allows them to strategically retain economic interest in idiosyncratically valuable loans. Furthermore, to the extent that mortgage servicing exhibits returns to scale, these counterfactual market designs have potentially large implications for market efficiency.