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Private-label RMBS fraud ran rampant before market crash, but who is guilty?

April 10, 2013

The financial crisis has raised concerns about the ability of market rules and regulations to ensure truthful disclosure of asset quality. There is good reason to worry.

In a recent paper (available here), we found that at least 10% of the private-label residential mortgage-backed securities sold before the crisis were misrepresented by the bankers who had packaged and sold them.

We also found that the propensity of intermediaries to sell misrepresented loans increased as the housing market boomed. The delinquency rate on these misrepresented loans was more than 60% greater than for loans that were accurately represented.

To arrive at this conclusion, we looked at two types of misrepresentations. In both cases, a loan was described to buyers as being less risky than it actually was.

The first concerned loans for properties that were characterized as being owner-occupied when, in fact, the owner wasn't living in the house.

The second involved loans that were represented as being the only mortgage on a property when the home had been financed with second mortgages that increased the overall debt of the borrower. Some loans suffered from both kinds of misrepresentations.

Given that we focus on just two relatively easy-to-quantify dimensions of asset quality, we estimate the minimum amount of forced repurchases of mortgages by financial intermediaries at $160 billion in a market of more than $2 trillion at its peak.           

The fraud we uncovered has several important implications for the future of the financial intermediation sector and for future regulatory design.

First, while misrepresented mortgage securities were more likely to be issued by now-bankrupt institutions such as Countrywide Financial Corp. or Lehman Brothers Holdings Inc., all underwriters involved in sale of mortgages participated in some type of misrepresentation, including the most reputable institutions, such as Goldman Sachs Group Inc. and JPMorgan Chase & Co.

This pervasive asset misrepresentation suggests that, in the short-run, most banks will face considerable legal and financial liability. Lenders are likely to react to the legal uncertainty by continuing to limit the supply of credit to borrowers.

In the longer term, however, efforts to address issues of transparency and trust in the private-label residential mortgage markets could help bring back capital, which had fled since 2008.            

Restoring confidence would require setting up a system of clear rules and responsibilities for lenders, brokers, underwriters, trustees and servicers. The alternative is to keep alive a system in which U.S. taxpayers provide an implicit subsidy of lending through government-sponsored enterprises such as Fannie Mae and Freddie Mac, which account for most U.S. residential loans.

Second, our findings show that while part of the misrepresentation was conducted by financial intermediaries, some of it also occurred at the borrower/broker level.

This compounded the difficulty of effective oversight because different agents in the supply chain of intermediation are regulated by different regulators. At the moment, lenders may be supervised by the Federal Reserve, state regulators, the Office of the Comptroller of the Currency or the Consumer Financial Protection Bureau, while the underwriters are regulated by the Securities and Exchange Commission.

Rather than continuing to speak in generalities about how the system needs to be changed ("all regulators should coordinate"), we need to focus on where and how the breakdowns occurred, and how regulators will share the appropriate information to identify such distortions in the future.

Enhancing the regulatory system could produce large long-term gains in the intermediation sector through more efficient allocation of credit.

There are two paths policymakers can take. The first, relatively easy course -- and the one that has been followed so far -- is to continue the rounds of clandestine settlements between banks and regulators that end investigations and bury misdeeds. This won't help restore trust or the flow of credit.

The second, more difficult approach is a thorough post-mortem that leads to structural changes. Our study takes a first step toward exposing those problems, but it also shows that there are no immediate fixes.            

For instance, several provisions in the Dodd-Frank Act that make financial intermediaries liable for misrepresentations may not be sufficiently strict. Intermediaries already faced significant ex-post liability due to contractual representations and warranties.

This was insufficient to prevent bad behavior, however, because the employees who made decisions were insulated from such liabilities.

Similarly, we found that the degree of misrepresentation was unrelated to the incentives offered to top management and to the quality of companies' risk-management practices. As a result, the solution may require changing the culture of the entire industry.

The wide scope of such an undertaking shouldn't deter policymakers. Investors must be able to hold the agents in the supply chain of intermediation accountable for the quality of the products they sell.

(Tomasz Piskorski is Edward S. Gordon Associate Professor of Real Estate and Finance at Columbia Business School. Amit Seru is Associate Professor of Finance at Booth School of Business at University of Chicago). 

The information conveyed in the above Op-ed reflects the views of the report's individual authors and is not reflective of the opinions of Housingwire or its editorial staff.

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