Screening for Moral Hazard and Adverse Selection: Evidence from the Home Equity Market Discussion of Paper by Sumit Agarwal, Brent Ambrose, Souphala Chomsisengphet, and Chulin Liu Doug McManus April 19, 2006

1 Office of the Chief Economist Main questions addressed in paper  Is there asymmetric information and adverse selection in home equity lending market  Find empirical support for both in data  Do Borrowers self-select loan contracts designed to reveal information about their risk level?  Conditional on borrowers choice of contract, does adverse selection exist?  How effective are secondary screening at mitigating adverse selection and moral hazard?  Examines these questions through a unique data set of loan applications in prime market  Adverse selection – subprime vs. prime lenders

2 Office of the Chief Economist Main Results of Paper  Controlling for age, income, employment, and other observables, borrowers’ choice of contract does reveal information about their risk level.  Less credit-worthy borrowers are likely to select contracts requiring less collateral  Controlling for borrower contract choice and other variable, lender continues to face adverse selection problem due to unobservable information.  Evidence: Correlation between ex ante collateral levels and ex post default risk  Credit losses are reduced through the use of counteroffers which induce borrowers to reveal borrower type and effort.

3 Office of the Chief Economist Empirical Evidence of Adverse Selection Focus is on ex post performance of loans from outright acceptances In absence of selection effects, current LTV rather than origination LTV have significant coefficients in regression Correlation between origination LTV and ex post default risk is evidence of adverse selection CLTV=(Home Equity Loan UPB + 1 st Lien Origination UPB)/(M-t-M HV) Find statistically significant coefficients on origination LTV which indicate higher LTV associated with incremental risk Eliminating alternative explanations: Econometric misspecification CLTV quadratic functional form misspecification induces LTV effect Try linear spline with knot points at 80 and 90 CLTV HELOC and HEL have CLTV relationship not captured by indicator variable – will result hold when reestimated separately Origination LTV as step function; CLTV as continuous function – why the inconsistency?

4 Office of the Chief Economist Impact of Competition on Adverse Selection  How would the interpretation of adverse selection results be altered if the firm faced a competitor that somewhat different variables in determining creditworthiness?  Winner’s curse in credit markets:  Broecker, T., 1990, “Credit-Worthiness Tests and Interbank Competition,” Econometrica, 58,  Riordan, M., 1993, “Competition and Bank Performance: A Theoretical Perspective,” in C. Mayer and X. Vives, eds., Capital Markets and Financial Intermediation, Cambridge University Press

5 Office of the Chief Economist Other Comments  Some of the language seems to presume motivation of designers of contract offering  “To counter adverse selection, the lender offers a menu of differential contracts (primary screening) to help borrowers self- select either lines-of-credit or fixed-term loans…”  From practitioner's motivation may be different  Example: Montgomery Mortgage Capital’s second lien program  What do authors know of lender intent in designing this set of offerings?  Use of Adverse Selection and Moral Hazard  Ausubel (1999): Adverse selection on observable vs. hidden information  Dey and Dunn (2004): ‘sorting-by-observed-risk’ vs. ‘sorting-by- private-information’  Moral hazard (hidden action) and repayment burden are used interchangeably – but are they?

6 Office of the Chief Economist Counteroffers  Why only 1 counteroffer? Why not menu?  What is intuition for labeling lowering LTV or switching from HEL to HELOC as ‘Moral hazard mitigation’ and labeling higher LTV or HELOC to HEL as ‘Adverse selection mitigation’?  These do not appear to be mutually exclusive categories?Why not really examine the 4 sets of outcomes separately.

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