Private mortgage securitization and adverse selection—New evidence from expected loan losses

Abstract

This paper studies expected loan loss and adverse selection in private mortgage securitization. The research extends the previous literature on securitization that has focused on default probability. Expected loan loss incorporates both the probability of default and loss given default and represents a comprehensive measure of loan quality that has the ultimate impact on lenders and investors. This new measure of loan quality reverses some of the findings in the previous literature. The disparity in results between the alternative measures is more pronounced among loans with higher expected loss given default. Our results provide new evidence of adverse selection in prime loans. This cherry-picking behavior does not hold for subprime loans.