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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.
D is correct. 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.
Author: LeetQuiz Editorial Team
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A credit manager, with expertise in the 2007-2009 US subprime mortgage crisis, oversees a bank's structured credit portfolio. The manager's task includes identifying potential issues arising from information exchange discrepancies (frictions) among participants involved in the securitization process. Identify the correct pairing of a potential friction in the securitization process and an appropriate method 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.