Anurag A Mehrotra, Adam D Nowak, and Patrick S Smith
Review of Finance, Volume 29, Issue 5, September 2025, Pages 1369–1395, https://doi.org/10.1093/rof/rfaf038
This paper tests for a principal-agent conflict in mortgage markets by examining the effect of securitization on servicers’ choice of asset liquidation channels: short sale versus real estate owned (REO). Short sales are voluntary liquidations in which the servicer allows the delinquent borrower to sell their house for less than what they owe on their mortgage. REOs are involuntary liquidations in which the servicer forecloses on the delinquent borrower, takes ownership of the house, and then liquidates the house. We develop a model that examines the economic factors influencing servicers’ decisions between short sales and REO liquidations. The model highlights the agency conflict arising from securitized loan servicers’ financial incentives to maximize their own net payoff from liquidations, which does not necessarily maximize the net proceeds investors receive.
We test whether securitized loan servicers’ proclivity for REOs represents a costly agency conflict by examining the efficiency of the two liquidation channels. We find REOs have lower average liquidation prices, higher average liquidation expenses, and longer liquidation timelines than short sales. Using just under 1.75 million housing transactions across four large U.S. cities from 2007-2016, we estimate houses liquidated via REOs sell for, on average, 5.6 percentage points or approximately $13,620 less than houses liquidated via short sales. Using loan-level data from the government-sponsored enterprises (GSEs), we find average REO liquidation expenses are almost three times as much as, or approximately $15,480 more than, short sale liquidation expenses. Taken together, the price discount and expense estimates indicate that liquidating a distressed house via an REO instead of a short sale reduces the net proceeds of the liquidation, on average, by over $29,000. The REO liquidation shortfall adversely affects private label securitization (PLS) investors but not GSE investors because GSE securitizations carry a credit guarantee. Instead, U.S. taxpayers bear this agency cost because the Federal Housing Finance Agency placed the GSEs in conservatorship in September 2008.
We reviewed over 5,000 pooling and servicing agreements (PSAs) and found few restrictions on short sales. Notably, the PSAs leading up to the financial crisis contain similar asset liquidation guidelines as those after the crisis in 2012 and 2013. We also find that the asset liquidation guidelines and short sale approval fees in the GSE servicing guides have remained largely unchanged since the 2007-2009 financial crisis. This suggests the costly agency conflicts we document still exist. Our results highlight the need to change servicing agreements to address these agency issues, and our findings can help inform those changes.