Appraisal Inflation and Private Mortgage Securitization

Lenders' access to soft information on appraisal inflation could lead to adverse selection in private mortgage securitization. Combining a nationwide mortgage data with a real estate transaction data and using a difference-in-differences empirical design, we document that securitized refinance loans have more than 3% higher appraisal inflation than portfolio loans at key LTV notches. At those notches, securitized mortgages are more likely to default by 19 to 50% in relative terms. The additional credit risk associated with the appraisal inflation on sold notch loans does not seem to be priced in the mortgage rate. The results are robust after controlling for servicer and lender effects, and hold when we infer appraisal inflation from repeat sale transactions or hedonic price estimates. These findings indicate the existence of adverse selection in private securitization where lenders sell mortgages with higher appraisal inflation to MBS investors and keep mortgages with lower appraisal bias in their own portfolios, without compensating investors for the additional credit risk.