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Misreporting of second liens in portfolio mortgages and privately securitized mortgages
Abstract
Using a unique nationwide mortgage servicing dataset, this paper investigates the underreporting of second liens in portfolio mortgages and compares underreporting in portfolio versus privately securitized mortgages. Portfolio loans have more than 40% of the second liens underreported. Low documentation securitized loans have a 47% (in relative terms) lower misreporting rate than observably similar portfolio loans. The portfolio setting allows us to provide strong evidence that misreporting happens in the early stages of intermediation by lenders. The decreased occurrence of misreporting in sold loans subjected to more rigorous screening indicates the effectiveness of MBS issuers' screening, though its overall effect remains limited. Further, we show that the lender‐MBS issuer affiliation also plays a role in misreporting.
The Dodd-Frank Act requires securitization sponsors to retain not less than a 5% share of the aggregate credit risk of the assets they securitize. This paper examines how the implementation of risk-retention requirements affected the market for securitized mortgage loans. Using a difference-in-difference empirical framework, I find that risk retention implementation is associated with mortgages being issued with markedly higher interest rates, yet notably lower loan-to-value ratios and higher income to debt-service ratios. In addition, after controlling for observable loan characteristics, loans subject to risk retention requirements appear to be less likely to become troubled. These findings suggest that the risk retention rules have made securitized loans safer in both observable and unobservable dimensions, yet are more expensive to borrowers. Further evidence suggests that the risk-retention rules are binding, with the amount of risk being retained following implementation roughly three times that of before, while lenders also seemed to accelerate the securitization of originated loans during the months immediately before the rules took effect.
During the housing boom, financially constrained home buyers artificially inflated transaction prices in order to draw larger mortgages. Using transaction data from Illinois that includes sellers' offers to inflate prices, I estimate that in 2005-2008, up to 16 percent of highly leveraged transactions had inflated prices of up to 9 percent. Inflated transactions were common in low-income neighborhoods and when intermediaries had a greater stake or an informational advantage. Borrowers who inflated prices were more likely to default, but their mortgage rates were not materially higher. Property prices in areas with a high rate of past price inflation exhibited momentum and high volatility. (JEL D14, E31, R31)
The first hints of trouble in the mortgage market surfaced in mid-2005, and conditions subsequently began to deteriorate rapidly. Mortgage defaults and delinquencies are particularly concentrated among borrowers whose mortgages are classified as "subprime" or "near-prime." The main factors underlying the rise in mortgage defaults appear to be declines in house prices and deteriorated underwriting standards, in particular an increase in loan-to-value ratios and in the share of mortgages with little or no documentation of income. Contrary to popular perception, the growth in unconventional mortgages products, such as those with prepayment penalties, interest-only periods, and teaser interest rates, does not appear to be a significant factor in defaults through mid-2008 because borrowers who had problems with these products could refinance into different mortgages. However, as markets realized the extent of the poor underwriting, underwriting standards tightened and borrowers began to face difficulties refinancing; this dynamic suggests that these unconventional products could pose problems going forward.
We demonstrate that a rapid expansion in the supply of mortgages driven by disintermediation explains a large fraction of recent U.S. house price appreciation and subsequent mortgage defaults. We identify the effect of shifts in the supply of mortgage credit by exploiting within-county variation across zip codes that differed in latent demand for mortgages in the mid 1990s. From 2001 to 2005, high latent demand zip codes experienced large relative decreases in denial rates, increases in mortgages originated, and increases in house price appreciation, despite the fact that these zip codes experienced significantly negative relative income and employment growth over this time period. These patterns for high latent demand zip codes were driven by a sharp relative increase in the fraction of loans sold by originators shortly after origination, a process which we refer to as "disintermediation." The increase in disintermediation-driven mortgage supply to high latent demand zip codes from 2001 to 2005 led to subsequent large increases in mortgage defaults from 2005 to 2007. Our results suggest that moral hazard on behalf of originators selling mortgages is a main culprit for the U.S. mortgage default crisis.
Loan performance varies by default probability and loss given default (LGD). While the relationship between securitization and default probability has been studied intensively, the effect of securitization on LGD remains unexplored. Using a unique dataset containing over forty thousand mortgage liquidations, this paper studies the effect of private securitization on LGD. We document that securitized loans incur higher LGD than observably similar portfolio loans. The results indicate that the effect comes mainly from the difference in loan quality between securitized and portfolio loans. Securitized opaque mortgages incur more than 18% (in relative terms) higher loan losses than observably similar portfolio loans. In addition, a difference‐in‐difference analysis provides evidence that pre‐crisis securitization standards contributed to higher loan losses. This article is protected by copyright. All rights reserved
We provide an analytic valuation framework to value second lien mortgages and first lien mortgages when homeowners can take out a second lien. We use the framework to value mortgage backed securities (MBS) and, in particular, quantify the greater risk associated with MBS backed by first liens that have “silent seconds”. Rating MBS without accounting for homeowners' equity extraction option results in much higher ratings than warranted by expected loss. While in our benchmark calibration the senior tranche rating should be A1 rather than Aaa, the big losers from the equity extraction option are the mezzanine tranches which are nearly wiped out.
This article is protected by copyright. All rights reserved
Agency conflicts inherent in securitization are viewed as having been a key contributor to the recent financial crisis. A review of empirical research for the U.S. home mortgage market suggests that the problem may not have been securitization itself, but rather the origination and distribution of observably riskier loans. Low‐documentation mortgages, for which asymmetric information problems are acute, performed especially poorly during the crisis. Low‐documentation mortgages performed better when included in deals where issuers were affiliated with lenders or had reputational capital at stake. Investors priced low‐documentation loan risk via higher required equity tranches and security yields.
Did securitization exacerbate the foreclosure crisis by altering mortgage servicing practices? I exploit the unanticipated freeze of private mortgage securitization in 2007 to provide new evidence that securitization increases foreclosure probability and decreases modification probability. These effects are economically large and persist over time even after implementation of the Home Affordable Modification Program (HAMP) in 2009. Using hand-collected data on the contractual terms of servicing agreements, I show that servicers typically have broad discretion to modify loans but face significant incentives favoring foreclosure. The evidence implies that securitization significantly increased foreclosure rates during and after the crisis.
We show that banks significantly underreport the risk in their trading book when they have lower equity capital. Specifically, a decrease in a bank’s equity capital results in substantially more violations of its self-reported risk levels in the following quarter. Underreporting is especially frequent during the critical periods of high systemic risk and for banks with larger trading operations. We exploit a discontinuity in the expected benefit of underreporting present in Basel regulations to provide further support for a causal link between capital-saving incentives and underreporting. Overall, we show that banks’ self-reported risk measures become least informative precisely when they matter the most.
Received April 30, 2015; editorial decision October, 27 2016 by Editor Itay Goldstein.
We study rating shopping on the MBS market. Outside of AAA, losses are higher on single-rated tranches than on multi-rated ones, and yields predict future losses for single-rated tranches, but not for multi-rated ones. Conversely, ratings have less explanatory power for single-rated tranches. These results suggest that single-rated tranches have been "shopped," whereby pessimistic ratings never reach the market. For AAA-rated MBS, by contrast, 93% receive two or three such ratings, and those ratings agree 97% of the time. This ratings convergence suggests that agencies "cater" to investors, who cannot purchase a tranche unless it has multiple AAA ratings. © The Author 2015. Published by Oxford University Press on behalf of The Society for Financial Studies.
This paper examines apparent fraud among securitized nonagency loans using three indicators: unreported second liens, owner occupancy misreporting, and appraisal overstatements. We find that around 48% of loans exhibited at least one indicator of misrepresentation. Surprisingly, misreporting is similar in both low and full documentation loans and is associated with a 51% higher likelihood of delinquency. Two-thirds of loans with unreported second liens had the same originator issuing both the first and second lien. Misrepresentations in MBS pools can explain substantial cross-sectional differences in future losses. Losses were predictable and initiating from apparent fraud by MBS underwriters and loan originators. © The Author 2016. Published by Oxford University Press on behalf of The Society for Financial Studies.
We examine the role of borrower concerns about future credit availability in mitigating the effects of adverse selection and income misrepresentation in the mortgage market. We show that the majority of additional risk associated with “low-doc” mortgages originated prior to the Great Recession was due to adverse selection on the part of borrowers who could verify income but chose not to. We provide novel evidence that these borrowers were more likely to inflate or exaggerate their income. Our analysis suggests that recent regulatory changes that have essentially eliminated the low-doc loan product would result in credit rationing against self-employed borrowers.
Borrowers with a pair of mortgages collateralized by the same property sometimes continue to make payments on one while defaulting on the other. We articulate a framework for understanding this performance mismatch that emphasizes two types of borrowers: those with stable equity positions who perceive they are facing moderate or temporary liquidity shocks, and those facing severe financial stress in combination with negative equity. The former have an incentive to enter mismatch and subsequently cure, while the latter would default on both contracts. Our empirical analysis using newly available, national samples of matched first- and second-lien mortgages supports this view.
In this article, the authors look at the second-lien issue, demonstrating that just over 50% of first liens in private label securitizations have a second (or higher lien) behind them. This includes simultaneous seconds, subsequent seconds, and both. The presence of a second lien raises the CLTV (combined loan-to-value ratio) by over 20 points and has a significant adverse impact on first-lien performance. The authors also show that the performance of simultaneous seconds is worse than subsequent seconds. The policy implication is that second liens are too important to ignore when considering loan modifications. And if modifications involving principal reductions begin to gain traction, the second-lien issue moves front and center.
This Article demonstrates that the housing bubble was driven by second mortgages to a much greater extent than previously appreciated. A unique feature of American law allows homeowners to take out second mortgages, without the consent or even knowledge of the first mortgage lender. The result is an underpricing and overextension of credit as first mortgage lenders cannot control or properly price for the risks created by second mortgages. Homeowners' unilateral right to encumber their properties with additional mortgage loans creates what we term the "leverage option" that is embedded in American mortgages. The leverage option is an unintended consequence of a federal law enacted to deal with seller financing arrangements that prevailed during the inflationary economy of the 1970s. The leverage option was of little importance until the housing bubble in the 2000s, as homeowners massively increased their leverage using second mortgages, often unbeknownst to first mortgage lenders, who were unable to price for the risk created by second mortgages on their collateral or for the risk of a credit-fueled asset price bubble. This Article demonstrates the problems that the leverage option causes for lenders, for homeowners (who pay for it, regardless of whether they want it), for regulators, and for the economy at large. We propose a discrete legal change that will convert the leverage option from being a mandatory, embedded option to a bargained-for, unembedded option that will enable efficient pricing and force the information about total mortgage market leverage that is necessary for macroprudential financial stability regulation.
Analyzing 916 collateralized debt obligations (CDOs), we find that a top credit rating agency frequently made positive adjustments beyond its main model that amounted to increasingly larger AAA tranche sizes. These adjustments are difficult to explain by likely determinants, but exhibit a clear pattern: CDOs with smaller model-implied AAA sizes receive larger adjustments. CDOs with larger adjustments experience more severe subsequent downgrading. Additionally, prior to April 2007, 91.2% of AAA-rated CDOs only comply with the credit rating agency's own AA default rate standard. Accounting for adjustments and the criterion deviation indicates that on average AAA tranches were structured to BBB support levels.
We study the impacts of the recently proposed risk retention regulation for asset securitization, i.e. the issuer has to retain a certain proportion of securitized assets. We also consider the frequently discussed measure to require the issuer disclose certain information of the securitized assets. In a dynamic model with asymmetric information between a risk-averse originating bank and a continuum of risk-averse investors, we find that it is impossible for a flat-rate retention requirement to be optimal for all asset types. Although both risk retention and information disclosure regulations are effective in reducing investors’ informational loss, neither can unconditionally enhance social welfare upon the unregulated case. For both measures, there are associated regulatory cost: risk retention regulation aggravates adverse selection problem because it undermines the channel of informational revelation by the choice of securitization intensity, and information disclosure requirement incurs a signalling cost by distorting banks’ securitization intensity in sending signals. Under an appropriate set of conditions we find that information disclosure requirement complements risk retention regulation when investors are sufficiently risk averse.
Borrower misreporting is associated with seriously adverse loan outcomes. Significantly more residential mortgage borrowers reported personal assets just above round number thresholds than just below. Borrowers who reported above-threshold assets were almost 25 percentage points more likely to become delinquent (mean delinquency was 20%). For applicants with unverified assets, the increase in delinquency was greater than 40 percentage points. Misreporting was most frequent in areas with low financial literacy or social capital. Incorporating behavioral cues such as threshold effects into a risk assessment model improves its ability to uncover delinquencies, though at a cost of mischaracterizing some safe loans.This article is protected by copyright. All rights reserved.
Home equity lending grew rapidly from 2000 to 2008 with balances more than tripling. In this paper, we examine the role this phenomenon may have played in increasing aggregate default risk during the mortgage crisis. We also document a relationship between growth in home equity lending and high house price depreciation and first mortgage default during the downturn of 2006 to 2009. Line of credit growth is shown to be associated with large increases in non-owner-occupied property purchase, suggesting that home equity lines of credit were tapped to fund such investments, exacerbating default rates during the market downturn.
Current explanations for the high rate of default and foreclosure in the U.S. emphasize house price fluctuations and lax lending criteria. Another explanation for default and foreclosure, which has generally been neglected in the academic literature but not by the FBI, is fraud. One impediment to identifying and measuring fraud is the lack of statistical tests capable of detecting it. This paper proposes a simple method to detect transactions where fraud may have occurred. The models proposed here are important for at least three reasons. First they can document the role of fraud in the mortgage foreclosure crisis. Second, they can serve as part of a forensic effort designed to detect and deter mortgage fraud. Third, they demonstrate that mortgage fraud distorts repeat sales house price indexes because it artificially elevates house prices during the period of fraud followed by a subsequent collapse due to the foreclosures sales. Accordingly, fraud can give the false impression that foreclosure lowers area house prices when it actually artificially inflates them. This suggests an alternative interpretation for the recent empirical literature on externalities from foreclosure.
No abstract available.
We examine whether securitization impacts renegotiation decisions of loan servicers, focusing on their decision to foreclose a delinquent loan. Conditional on a loan becoming seriously delinquent, we find a significantly lower foreclosure rate associated with bank-held loans when compared to similar securitized loans: across various specifications and origination vintages, the foreclosure rate of delinquent bank-held loans is 3% to 7% lower in absolute terms (13% to 32% in relative terms). There is a substantial heterogeneity in these effects with large effects among borrowers with better credit quality and small effects among lower quality borrowers. A quasi-experiment that exploits a plausibly exogenous variation in securitization status of a delinquent loan confirms these results.
A central question surrounding the current subprime crisis is whether the securitization process reduced the incentives of
financial intermediaries to carefully screen borrowers. We examine this issue empirically using data on securitized subprime
mortgage loan contracts in the United States. We exploit a specific rule of thumb in the lending market to generate exogenous variation in the ease of securitization and compare the composition and performance
of lenders' portfolios around the ad hoc threshold. Conditional on being securitized, the portfolio with greater ease of securitization defaults by around 10%–25%
more than a similar risk profile group with a lesser ease of securitization. We conduct additional analyses to rule out differential
selection by market participants around the threshold and lenders employing an optimal screening cutoff unrelated to securitization
as alternative explanations. The results are confined to loans where intermediaries' screening effort may be relevant and
soft information about borrowers determines their creditworthiness. Our findings suggest that existing securitization practices
did adversely affect the screening incentives of subprime lenders.
Empirical research on mortgage default in the single-family market has focused on the value of the borrower's put option using house price indices to estimate contemporaneous loan-to-value ratio or the probability of negative equity. But since the borrower possesses the option to increase leverage by taking on additional debt secured by junior liens subsequent to loan origination (a phenomenon termed here equity dilution), even a perfect house price adjustment cannot be expected to accurately measure changes in borrower equity over time. Since junior liens are generally unobservable to senior debt holders, proxies are required in empirical applications. This paper employs an independent estimate of junior lien probability developed from the 1998 Survey of Consumer Finances combined with loan level mortgage performance data to examine the role junior liens play in increasing default risk. Copyright 2004 by the American Real Estate and Urban Economics Association