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Answer: 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.
The correct answer is D. The friction between the servicer and the mortgagor is a moral hazard problem. The servicer and the mortgagor do not share the full consequence of bad outcomes, such as loan foreclosure or delinquencies. The mortgagor typically has limited liability and may not have the incentive to maintain the property, especially if it is close to foreclosure. Meanwhile, the servicer's role is to act in the best interest of the investors by ensuring the payment of property taxes and insurance, and generally maintaining the property. To mitigate this friction, the solution is to require the mortgagor to escrow funds for insurance and tax payments, which can help reduce the risk of foreclosure. This mechanism ensures that the necessary payments are made, aligning the interests of both the servicer and the mortgagor, and reducing the moral hazard problem.
Author: LeetQuiz Editorial Team
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A credit manager, possessing in-depth understanding of the 2007-2009 US subprime mortgage crisis, is overseeing a bank's structured credit portfolio to identify potential problems related to information exchange (frictions) among the entities involved in the securitization process. Which of the following pairs accurately identifies a potential friction in the securitization process and an effective strategy 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 securitized products 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.