Servicer Contracts and the Design of Mortgage-Backed Security Pools

We develop a unified model of mortgage and servicer contracts. Renegotiating mortgage contracts following default is strictly Pareto improving, if the lender gathers updated information. An incentive compatible servicer contract requires the servicer to hold a risk position that has a value strictly greater than the cost of exerting effort. This risk position cannot in general be approximated with a horizontal "first-loss" position. If servicers do not sufficiently value investment in MBSs, forming a nondiversified pool to preserve pool-wide information may increase MBS value