There's no question that there was a fair amount of mortgage fraud during the financial crisis. But where did it come from? Actually, that's not the right question: we know where it came from. Borrowers and mortgage brokers falsified the documents.
This is obviously not good, but you can almost see how it started. When banks started using hard cutoffs enforced by computer systems, you would get the crazy result that someone with an income of $50,150 would qualify for a mortgage, while someone with an income of $50,000 would not. Now, there is no one making $50,000 a year for whom $150 is the difference between keeping current, and foreclosure--not when they could close the gap by picking up a couple of shifts at Pizza Hut.
So mortgage brokers started cheating a little to get around an irrational system, and by the time that the bubble was in full roar, they weren't just cheating a little. Private debts and child support payments were left off applications, fake sources of income were invented, the need for a second mortgage was concealed, investors were misrepresented as primary residents. The loans that investors were told they were buying were not quite what they got. And many of those loans, naturally, ended up in default.
But did the originators know? Naturally, they maintain that they didn't. A new paper by Tomasz Piskorski, Amit Seru, and James Witkin, however, suggests that they did:
We find that mortgages with misrepresented owner occupancy status are charged interest rates that are higher when compared with loans with similar characteristics and where the property was truthfully reported as being the primary residence of the borrower. Similarly, interest rates on loans with misrepresented second liens are generally higher when compared with loans with similar characteristics and no second lien. Given the increased defaults of these misrepresented loans, this suggests that lenders were partly aware of the higher risk of these loans. Strikingly, however, we find that the interest rate markups on the misrepresented loans are much smaller relative to loans where the property was truthfully disclosed as not being primary residence of the borrower and as having a higher lien. This suggests that relative to prevailing interest pricing of that time, interest rates on misrepresented mortgages did not fully reflect their higher default risk.
But not so fast! Arnold Kling, who actually knows quite a bit about the mechanics of mortgage underwriting (rather than, say, the macroeconomic theory of house prices and the captial stock), asks what the fraud consisted of:
The authors go on to write,
In contrast, of all mortgages identified as having misreported second lien status to investors, 93.3% had a second lien reported in the New Century database. This confirms that the lenders were often aware of the presence of second liens, and hence their underreporting occurs later in the process of intermediation.
Consider these possibilities:
1. New Century sold loans in the “TBA market,” meaning that investors committed to buy the loans before they were closed. New Century sold these loans as not having seconds, because it had no idea about them. Lo and behold, when the borrowers went to closing, they needed a second loan in order to make the down payment. New Century then recorded in its database the existence of the seconds, but there was no further communication with the investors.
2. New Century new darn well all along about the seconds, but they have two records in their database–a record that they made for internal purposes and a record that they gave to investors.
#1 is still fraud, but it is not as blatantly intentional as #2. I suspect it was #1.
Arnold finds #2 more likely.
This resonates with something recently written by Noah Millman, a former structured finance guy and one of my favorite bloggers. Millman agrees that there's some sort of fraud, at least of the "I don't want to know" sort, but argues that this attitude existed on both sides of the trade.
In other words: JPMorgan – and other banks in the mortgage derivatives business – had powerful incentives to commit what looks like fraud (though Yglesias is careful to note that he isn’t equipped to speak to the question of legal liability).
The thing to remember, though, is that the incentives for doing this sort of thing exist on both sides of the desk in any transaction. You would think that a buyer of a security would want full disclosure of all the risks, and the seller would want to hide potentially damaging information. And relative to some market benchmark, that’s generally true – a less-scrupulous seller will try to get away with disclosing less than his competitors, a more conservative buyer to get more information than her competitors. But the benchmark itself moves, and both sides are complicit in moving it during bubbles – because in bubbles, market participants are more worried about missing out on profit opportunities than with incurring losses.
At the height of the bubble, if you brought a piece of paper to market with a high percentage of no-doc “liar” loans in the portfolio, the market would demand a higher interest rate because of the higher risk that these loans would go bad. But eventually the rate would be high enough that investors convinced themselves they were being compensated for that risk – and they wanted to convince themselves, because they needed the yield.
Maybe the real lesson is that during a bubble, there is money to be made in breaking the rules. And so everyone finds ways to convince themselves that the rules don't matter.
We should take this possibility seriously, because it suggests that all the rules you carefully construct to ensure safe banking will tend to come undone during a bubble. People will push the envelope, see no consequence, and conclude that the rules must be wrong. The rules will become casualties of the very bubble they were supposed to prevent. And some sort of fraud-lite will be committed by everybody, against everybody--including themselves.
For such a diverse city, the L.A. City Council is a depressing bastion of likeminded men.
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