Securitization and optimal foreclosure

•A model of joint determination of the securitization and the foreclosure policy of mortgages is developed.•The optimal foreclosure policy is tougher than in the first-best and leads to higher loan losses, in order to mitigate the adverse selection problem in securitization.•Foreclosure-prevention policies could discourage mortgage lender’s origination effort, reducing the quality of securitised mortgages.•Novel testable predictions on the effect of mortgage securitisation on foreclosure rates, loan performance, and mortgage servicing are provided. Does securitization distort the foreclosure decisions of non-performing mortgages? In a model of mortgage-backed securitization with an endogenous foreclosure policy, we find that the securitizing bank adopts a tougher foreclosure policy than the first-best, despite resulting in higher loan losses. This is optimal because foreclosure mitigates the adverse selection problem in securitization by making the optimal security, a risky debt, less information-sensitive. We further show that policies that limit mortgage foreclosure would discourage the bank’s ex ante screening effort, reducing the quality of securitized mortgages. Our model yields novel testable predictions on the effect of mortgage securitization on foreclosure rates, loan performance, and mortgage servicing.