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. An alternative, forming a nondiversified pool, preserves pool-wide information, avoids the cost of an incentive compatible servicer contract, and may increase MBS value.