Which of the following statements regarding frictions in the securitization of subprime mortgages is correct?
A.The arranger will typically have an information advantage over the originator with regard to the quality of the loans securitized.
B.The originator will typically have an information advantage over the arranger,which can create an incentive for the originator to collaborate with the borrower in filing false loan applications.
C.The major credit rating agencies are paid by investors for their rating service of mortgage-backed securities,and this creates a potential conflict of interest.
D.The use of escrow accounts for insurance and tax payments eliminates the risk of foreclosure.
One of the key frictions in the process of securitization involves an information problem between the originator and arranger. In particular, the originator has an information advantage over the arranger with regard to the quality of the borrower. Without adequate safeguards in place, an originator can have the incentive to collaborate with a borrower in order to make significant misrepresentations on the loan application. Depending on the situation, this could be either construed as predatory lending (where the lender convinces the borrower to borrow too large of a sum given the borrower’s financial situation) or predatory borrowing (the borrower convinces the lender to lend too large a sum).
The major rating agencies are not paid by the investors. Escrow accounts can forestall but not eliminate the risk of foreclosure.