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Banks which originate mortgage loans may either hold the loans themselves until maturity or package the loans into mortgage-backed securities for sale to investors (securitization).

Banks which originate mortgage loans may either hold the loans themselves until maturity or package the loans into mortgage-backed securities for sale to investors ("securitization"). To attract institutional investors like pension funds and trusts, issuers of residential securities need to meet required credit ratings. The U.S. Securities Exchange Commission has registered only three credit rating agencies -- Fitch Ratings, Moody's Investor Services, and Standard & Poor's Ratings Services. (a) Suppose that A Bank originates mortgages and packages them into a mortgage-backed security for sale to B Fund. Explain the asymmetry of information between the A Bank and B Fund over the credit-worthiness of the mortgage borrowers. (b) Explain how A Bank is subject to moral hazard relative to B Fund. (c) Would the bank take more care in screening the borrower for a mortgage loan that it will hold until maturity or for a loan that it will securitize? (d) A Bank would hire a credit rating agency to provide a rating. B Fund would rely on the rating. Explain how the credit rating agency is subject to moral hazard relative to B Fund. (e) Suggest one method can help solve the moral hazard problem relative to B Fund.

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