Asset Quality Misrepresentation by Financial Intermediaries: Evidence from the RMBS Market

• Published date: 01 December 2015
• DOI: http://doi.org/10.1111/jofi.12271
• Author: AMIT SERU,TOMASZ PISKORSKI,JAMES WITKIN
• Date: 01 December 2015

THE JOURNAL OF FINANCE •VOL. LXX, NO. 6 •DECEMBER 2015

Asset Quality Misrepresentation by Financial

Intermediaries: Evidence from the RMBS Market

TOMASZ PISKORSKI, AMIT SERU, and JAMES WITKIN∗

ABSTRACT

We document that contractual disclosures by intermediaries during the sale of mort-

gages contained false information about the borrower’s housing equity in 7–14%

of loans. The rate of misrepresented loan default was 70% higher than for similar

loans. These misrepresentations likely occurred late in the intermediation and ex-

ist among securities sold by all reputable intermediaries. Investors—including large

institutions—holding securities with misrepresented collateral suffered severe losses

due to loan defaults, price declines, and ratings downgrades. Pools with misrepresen-

tations were not issued at a discount. Misrepresentation on another easy-to-quantify

dimension shows that these effects are a conservative lower bound.

MARKET RULES AND REGULATIONS that require disclosure of information and pro-

hibit misleading statements on the financial products being manufactured by

intermediaries play an important role in the functioning of capital markets

(Akerlof (1970)). However, the nature of intermediation has changed dramati-

cally over the past decade, with the introduction of more agents in the supply

chain of credit (Loutskina and Strahan (2009), Keys et al. (2013), Nadauld

and Sherlund (2013)) potentially weakening the ability of existing market ar-

rangements and regulatory oversight to ensure truthful disclosure of asset

quality. This concern has gained momentum in the aftermath of the recent

crisis, which witnessed a precipitous decline in the value of supposedly safe

∗TomaszPiskorski is at Columbia Business School, Amit Seru is at the University of Chicago and

the National Bureau of Economics Research, and James Witkin is at Columbia Business School.

Piskorski thanks the Paul Milstein Center for Real Estate at Columbia Business School and the

NSF (Grant 1124188) for financial support. Seru thanks the Initiative on Global Markets at Booth

for financial support. Witkin thanks the Paul milstein Center for Real Estate at Columbia Busi-

ness School for financial support. We thank Gene Amromin, Charlie Calomiris, John Cochrane,

Gene Fama, John Griffin, Chris Mayer, Lasse Pedersen, Tyler Shumway, Ken Singleton, Richard

Stanton, Phil Strahan, Amir Sufi, and Luigi Zingales, two anonymous referees, as well as seminar

and conference participants at AQR, Columbia Business School, Purdue, Rice, Rutgers, Stockholm

University,the Securities and Exchange Commission, the University of Illinois, Global Justice Fo-

rum, National Bank of Poland, NBER Economics of Real Estate summer meeting, AFA, AREUEA,

NUS-IRES Symposium, Red Rock Finance conference, Summer Real Estate Symposium, and UC

Berkeley Conference on Fraud and Misconduct for valuable comments. We are grateful to Equifax

and BlackBox Logic for their data. We also thank Ing-Haw Cheng, Andrew Ellul, and Taylor

Nadauld for sharing their data. We are indebted to Vivek Sampathkumar and Zach Wade for

outstanding research assistance.

DOI: 10.1111/jofi.12271

2635

2636 The Journal of Finance R

securities as well as large investor losses (Acharya, Schnabl, and Suarez

(2013)).1This paper adds to the debate by quantifying the extent to which

buyers may have received false information about the true quality of assets by

the sellers of the securities, investigating where in the supply chain of credit

these misrepresentations likely occurred, and examining the economic conse-

quences of such misrepresentations.

We focus on misrepresentation of the asset quality of securities collateralized

by residential mortgages originated without government guarantees, that is,

nonagency residential mortgage-backed securities (RMBS), a $2 trillion mar-

ket in 2007 (Keys et al. (2013)). These misrepresentations are not instances

of the usual asymmetric information problem in which buyers know less than

the seller. Rather, we argue that they are instances in which sellers provided

buyers false information on asset characteristics during the contractual disclo-

sure process. In the first part of the paper we focus on detecting such instances

and where in the supply chain of credit these might have occurred. In the sec-

ond part, we focus on understanding whether these misrepresentations were

costly for buyers. The null hypothesis is that these misrepresentations, even if

present, did not have a meaningful impact, either because they did not mat-

ter for performance or because investors were able to differentiate pools with

versus without misrepresented assets.

As we discuss in Section I, the RMBS securitization process involves aggre-

gating mortgages into loan trusts, either through direct origination or indirect

acquisition, and using their underlying cash flows to issue securities. The sale

of these securities is organized by underwriters who, as part of this process,

collect, verify, and certify information regarding the quality of the underlying

collateral backing these securities. The underwriters in this market are large,

reputable financial intermediaries, which are considered more sophisticated

than the buyers in this market, which are typically institutional investors

such as pension funds, mutual funds, and insurance companies. The underly-

ing collateral data collected during mortgage origination are made available to

investors of these securities, both in aggregated form in prospectuses as well

as in the form of detailed loan files obtained from originators (lenders).

Our analysis focuses on an easy-to-quantify dimension of asset quality mis-

representation during the sale of mortgages: loans that are reported as having

no other lien when in fact the properties backing the first (senior) securitized

mortgage were also financed with a simultaneously originated second (junior)

mortgage. The consequence of this type of misrepresentation is that the re-

ported combined loan-to-value ratio (CLTV) at origination is materially lower

than the actual CLTV of the loan. Since the true equity stake of the borrower

on such a loan is lower than the reported one, these loans carry significantly

higher default risk. As we show, a loan’s CLTV is one of the most fundamental

1Critics of imposing more regulation argue that reputational concerns of large, well-established

financial intermediaries would prevent such violations of investors’ rights. In contrast, proponents

of increased regulation argue that intermediaries were able to exploit investors despite their

reputation (and existing regulation).

Asset Quality Misrepresentation by Financial Intermediaries 2637

metrics that market participants take into account when assessing the value

and risk of mortgage securities. Thus, misrepresentation on this dimension

implies that RMBS investors took on more risk than was implied by the con-

tractual disclosure.

We identify second lien misrepresentation by comparing the characteristics

of mortgages disclosed to investors at the time of sale with those in a data

set provided by a credit bureau. Specifically, as we discuss in Section II,we

use a data set provided by a credit bureau that matches loan-level data on

mortgages disclosed to investors (BlackBox) with highly accurate data on these

loans from consumer credit files at the same bureau (Equifax). A high-quality

matched data set is critical for constructing measures of misrepresentation.

Several pieces of evidence reported in Section III convincingly demonstrate the

quality of the match.

In Section IV, we show that a significant degree of misrepresentation of col-

lateral quality exists across nonagency RMBS pools. More than 7% of loans

(13.6% using a broader definition) reported to investors as not having a junior

lien did have a second lien. On average these loan files understate the true

CLTV by about 20 percentage points. The misrepresentations are concentrated

among loans used to purchase properties where more than 14% of loans re-

ported to investors as not having a junior lien are misrepresented. Moreover,

misrepresentations are not confined to loans with reported low documentation

status.

The second-lien misrepresentation captures economically meaningful infor-

mation about asset quality. Loans with a misrepresented higher lien, which we

find are often fully documented, have about 10 percentage points higher like-

lihood of default compared to loans with similar characteristics but no higher

lien. This estimate is large, implying about 70% higher mean default rate of

misrepresented loans relative to loans without higher liens. Lenders charged

somewhat higher interest rates on loans with misrepresented second liens rel-

ative to similar loans with no such lien. However, the interest rate markups on

the misrepresented loans were much smaller relative to loans with similar or

lower default risk, that is, those that truthfully disclosed a higher lien.

In Section V, we investigate which entities—the borrower, lender, and

underwriter—might have been aware of misrepresentation more systemati-

cally. To do so, we exploit an internal database of a large subprime lender,

which allows us to observe the data that the lender collected during origina-

tion. Comparing this information with that disclosed to the investors, we find

that the lender knew second liens were present in almost all cases of second-

lien misrepresentation, which implies that the misreporting occurred later in

the supply chain of credit (i.e., within the boundaries of the financial industry).

This evidence is not particular to one large lender; we confirm these findings

in a broader sample of lenders using the registry of deeds that records the

legal titles to the properties. Almost all mortgages that we identify as having

a misreported second lien have such liens recorded in the registry of deeds.

Notably, virtually allof the misreported second-lien loans are originated by the

same bank responsible for the first-lien loans sold to investors. Moreover, in