Banks Hurt More By Liar Loans Than Secondary Market Investors

Posted by: Mara Der Hovanesian on July 21

Here’s a surprising bit of research coming out of study by some Columbia University professors: Banks lowered their standards on underwriting because they assumed they’d push the risk and iffy loans off to investors. They were wrong. Instead, banks ended up carrying the worst of those loans on the books because investors were smart enough to “cherry pick” the best of the bunch for their own portfolio.

Wei Jiang, associate professor in finance and economics says the study is the first to analyze the details of "liar’s loans" based on large-sample micro data. The data include all loans issued by an unnamed but "major" national mortgage bank from 2004 to 2008 and their performance until 2009.

By early 2009, so-called liar loans issued since the beginning of 2004 reached a cumulative delinquency (delinquency of 60 days or more) rate of 28%, about half of which are in the state of short sale or foreclosure, the study says.

Some of the rest of the findings are pretty much what you'd expect. Jiang and company looked at how origination channels and loan sales affect mortgage delinquency. By comparing loans originated by the bank and by mortgage brokers, the study finds the latter are 50% more likely to be delinquent. Among the brokers, so-called correspondent brokers (who have long-term or even exclusive relation with the bank, he explains) did far better than the non-correspondents.

The data also suggest massive information falsification among low-doc loans--surprise, surprise. For example, the study finds that on average reported income (income that is not verified among low- or no-doc loans) was exaggerated by brokers or the homebuyers by some 20%.

But what's most alarming is the extent to which banks shot themselves in the foot by lowering lending standards to the point of the absurd.

Observes Jiang: "While the bank tends to apply lower lending standards on loans that they think are more likely to be sold (securitized), it ends up with the worst quality loans because investors, or the buyers of the loans in packaged securities, were able to cherry-pick after the loans are originated...While many blame the presence of the secondary market for the emergence of 'liars’ loans,' we find that ironically these loans hurt the originating bank more than it did the secondary market."

Reader Comments

Gary Fischer

July 21, 2009 10:11 PM

I think this is propoganda. I was a real estate agent in FL watching a lot of the no qual, stated income loans go through. At least from what I saw, these sub-prime loans were often sold in bundles of loans which is why it was so easy for banks to approve almost anyone. All they had to do is throw known bad loans in with some that appeared sound and investors were faced with all or nothing investments not the ability to "cherry pick". Even if what this article says is true, are we supposed to feel sorry for banks because they wrote bad loans and then weren't able to move them to a sucker investor?

Aaron

July 22, 2009 11:34 AM

When I went looking at new homes in 2001 and 2002, every developer had its own in-house financing unit and the representatives at the model homes would only talk about ARMs and financing down payments. If credit was spotty due to unpaid obligations, they'd work in additional money to pay that off as well. All with just a statement about income and work history.

Not one person out of over a dozen developments and a half dozen companies could coherently talk about traditional mortgages, which is what I wanted. I ended up walking away and renting because with that sort of across-the-board irresponsibility I had no doubt but that when the loans reset the housing market would tank even if I could get them to build me a house financed through a traditional mortgage (which was met with downright hostility at a number of places).

I imagine that these "in-house financing units" functioned as mortgage brokers rather than independent lending units. I also imagine that there must have been a profit incentive from the banks to chase ARMs so aggressively and exclusively. Unfortunately, at least two friends of mine fell into the trap without reading the fine print because they trusted the "experts" who "interpreted" the documents (the agents of the developers).

Squeezebox

July 22, 2009 12:34 PM

Aaron, did you ever look at USED houses? My realtor suggested that I use a mortgage broker, but I told her I wanted a bank I knew. She had a contact there and I got an 80/20 fixed with no trouble at all. I refinanced it 3 years later with an FHA fixed rate loan at a terriffic rate. If you don't like the dealer, find another, don't continue to waste money renting.

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BusinessWeek's Adrienne Carter, Jessica Silver-Greenberg, and David Henry deconstruct the mysteries of high finance, Wall Street, and hedge funds for pros and ordinary investors. E-mail them directly if you've got tips about big deals, a hedge fund, or even securities industry gossip.

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