Question

A credit manager who is well versed in lessons learned from the 2007 - 2009 subprime mortgage crisis in the US is overseeing the structured credit book of a bank in order to identify potential frictions in the securitization process. Which of the following is a correct combination of a potential friction in the securitization process and an appropriate mechanism to mitigate that friction?

A. Friction between the asset manager and the investor: adverse selection problem. This problem can be mitigated by the asset manager charging due diligence fees to the investor.

B. Friction between the arranger and the originator: model error problem. This problem can be mitigated by the arranger providing a credit enhancement to the securities with its own funding.

C. Friction between the investor and credit rating agencies: Principal-agent conflict. This problem can be mitigated by requiring credit rating agencies to be paid by originators and not by investors for their rating services.

D. Friction between the servicer and the mortgagor: Moral hazard problem. This problem can be mitigated by requiring the mortgagor to escrow funds for insurance and tax payments.

Answer 1

The answer is option "D" - Friction between the servicer and the mortgagor: Moral hazard problem. This problem can be mitigated by requiring the mortgagor to escrow funds for insurance and tax payments.

Explanation: The mortgagor has to pay insurance and tax payments for maintaining the value of the underlying assets. During delinquency the mortgagor has little or no incentive to pay insurance and tax payments. For mitigation the mortgagor should regularly escrow funds for insurance and tax payments.