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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 (e.g., loan foreclosure, delinquencies). The mortgagor typically has limited liability and has little incentive to expend effort or resources to maintain a property close to foreclosure. On the other hand, the servicer strives to work in investors' best interest by keeping up with payment of property taxes and insurance, and generally maintaining the property. A way to mitigate this friction is to require the mortgagor to regularly escrow funds for insurance and tax payments in order to forestall the risk of foreclosure. Option A is incorrect because the friction between the asset manager and the investor is a principal-agent problem, not an adverse selection problem. The investor is less sophisticated than the asset manager and does not fully understand the investment strategy, leading to uncertainty about the manager's ability and effort in conducting due diligence. Option B is incorrect as the friction between the arranger and the originator is a predatory borrowing and lending problem, not a model error problem. The originator has an information advantage over the arranger regarding the quality of the borrower, which can lead to misrepresentations on the loan application if not mitigated by thorough due diligence and capital requirements for the originator to buy back problem loans. Option C is incorrect because the friction between the investor and credit rating agencies is a model error problem. Investors cannot assess the efficacy of rating agency models and are susceptible to errors, compounded by the potential conflict of interest as rating agencies are paid by the arranger, not the investors.
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A credit manager, well-versed in the lessons learned from the US subprime mortgage crisis of 2007-2009, is overseeing the structured credit portfolio for a financial institution. Their objective is to identify potential issues related to communication frictions among the different stakeholders involved in the securitization process. What is the correct pairing of a potential friction within the securitization process along with an appropriate 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.