# Presentation: 030513

## 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**

## 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

- Office of the Chief Economist

**Notes:**
Normal Times
Stress Periods
Tradeoff with portfolio needs

## 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.

- 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 + 1st 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?

- 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, 429-452
- 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

- 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?

- 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.

- Office of the Chief Economist

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- Office of the Chief Economist