We find that mortgages with misrepresented owner occupancy status are charged interest rates that are higher when compared with loans with similar characteristics and where the property was truthfully reported as being the primary residence of the borrower. Similarly, interest rates on loans with misrepresented second liens are generally higher when compared with loans with similar characteristics and no second lien. Given the increased defaults of these misrepresented loans, this suggests that lenders were partly aware of the higher risk of these loans. Strikingly, however, we find that the interest rate markups on the misrepresented loans are much smaller relative to loans where the property was truthfully disclosed as not being primary residence of the borrower and as having a higher lien. This suggests that relative to prevailing interest pricing of that time, interest rates on misrepresented mortgages did not fully reflect their higher default risk.
Pointer from Mark Thoma.
My thinking goes like this. There are some loan brokers who have a reputation for participating in fraud, so they have a smaller choice of lenders that will do business with them. Customers of those brokers end up paying higher rates as a result. The lenders who do not blacklist those brokers wind up being adversely selected. They think they are getting a higher profit margin on these loans than other loans, but in fact the reason that they can get away with (slightly) higher interest rates is that other lenders (rightly) will not touch loans from the same source.
As I said when I first heard about this paper from Luigi Zingales but did not know where to find it,
Zingales says that the bankers should be prosecuted. He makes it sound as if the lenders would record a loan internally as backed by an investment property and report it to investors as an owner-occupied home. That would require a much more complex conspiratorial action on the part of the lender, and until I learn otherwise, I will doubt that it happened.
Indeed, the authors of the paper looked at one infamous now-bankrupt subprime lender, New Century.
Of all loans in this sample that we identified as having misreported nonowner-occupied status, none was reported as being for non-owner-occupied properties in the New Century database. This evidence suggests that the misrepresentation concerning owner-occupancy status was made early in the origination process, possibly by the borrower or broker originating the loan on behalf of New Century.
The authors go on to write,
In contrast, of all mortgages identified as having misreported second lien status to investors, 93.3% had a second lien reported in the New Century database. This confirms that the lenders were often aware of the presence of second liens, and hence their underreporting occurs later in the process of intermediation.
Consider these possibilities:
1. New Century sold loans in the “TBA market,” meaning that investors committed to buy the loans before they were closed. New Century sold these loans as not having seconds, because it had no idea about them. Lo and behold, when the borrowers went to closing, they needed a second loan in order to make the down payment. New Century then recorded in its database the existence of the seconds, but there was no further communication with the investors.
2. New Century new darn well all along about the seconds, but they have two records in their database–a record that they made for internal purposes and a record that they gave to investors.
#1 is still fraud, but it is not as blatantly intentional as #2. I suspect it was #1.
When my online housing course starts (by the end of this month, I am now told), I want to share my knowledge of these institutional issues.