Researchers from Columbia University and the University of Chicago have done mortgage investors a big favor by teasing out two examples of how investors were fed bad information on the safety of so-called private-label subprime mortgages during the housing boom.
Private-label subprime mortgages are those no-down payment and other exotic subprime mortgages that Wall Street securitizers packaged into non-federally backed securities for sale to investors around the world. These were the first securities to go bust once home prices stopped rising and which a U.S. Treasury report two years ago said were the fuel that led to the mortgage crisis and, by extension, the economic crisis that we now call the Great Recession.
What the Columbia and University of Chicago researchers show in a report they just released is that the underwriters of these private-label mortgage backed securities misrepresented key facts about the loans in a sizable percentage of the cases. What’s more, the researchers limited their investigation to just two indicators of asset quality: the owner-occupancy status of the loans at origination and the presence or absence of second-lien financing.
The researchers raise the possibility that, based on the findings from just these two quality indicators, other indicators might have similar rates of incorrect information, although the researchers don’t know that for sure because they didn’t investigate other indicators.
“The results in our paper indicate the presence of sizeable asset misrepresentations even among the most reputable underwriters,” say the researchers, Tomasz Piskorski and James Witkin of Columbia University, and Amit Seru of the University of Chicago.
Based on their research into the loans collateralizing private-label securities in just one year, 2007, the researchers found misrepresentation in about 10 percent of the cases. “Misrepresentations on just [these] two relatively easy-to-quantify dimensions of asset quality could result in forced repurchases of mortgages by intermediaries in upwards of $160 billion,” they say.
According to one industry analyst, the nature of these findings suggest that federal banking regulators, as they proceed with forthcoming rules on qualified residential mortgages (QRM), which apply just to securitized loans, might want to switch their focus away from underwriting factors such as amount of down payment and instead focus on issues related to transparency.
Under the rules being written for QRM, regulators would require lenders to maintain at least 5 percent of the loan amount on their books to ensure they have some skin in the game for each loan they make that’s packaged into a security and sold to investors. That would likely increase costs to borrowers, but lenders would have the option to make loans with no 5 percent holdback if they originate the loans to the QRM standards. These standard haven’t been finalized yet, so we don’t know what they’ll entail, but there have been proposals to require a minimum down payment, among other things.
What the research suggests is that minimum down payment and other requirements like that might be less helpful than focusing on transparency on the loan quality that goes into the security. That’s what this new research shows: if investors are given accurate information about loan quality, they can decide for themselves whether the risk of investing in the loans makes sense for them and, if it does, how much they’re willing to pay for it.
Access the report, Asset Quality Misrepresentation by Financial Intermediaries: Evidence from RMBS.