Banks Hurt More By Liar Loans Than Secondary Market Investors
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."