Where Did Misrepresentations Occur?

V. Where Did Misrepresentations Occur?

The data do not allow us to directly investigate where in the supply chain of credit (i.e., borrower, lender, and/or underwriter) misrepresentations took place. However, results in Section IV suggest that lenders were at least partly aware of the higher default risk of misrepresented loans, since they charged higher interest rates on misrepresented loans and these loans were often fully documented. We shed more light on this issue by investigating more directly if lenders were aware of the second-lien misrepresentations.

A. Evidence from New Century Loan Files We start by using internal bank-level data from one of the largest sub-

prime mortgage lenders during the housing boom (New Century Financial). These data are provided by IP Recovery, which, as part of the New Century bankruptcy proceedings, purchased a comprehensive collection of New Century data records. The advantage of this data set is that it contains loan characteris- tics that were internally recorded by the lender at loan origination. These data are unlikely to have been manipulated since New Century entered bankruptcy quite quickly at the start of the crisis and this data set was sold during the bankruptcy process by an independent trustee. The data allow us to assess whether New Century was aware of second liens for loans that were misrepre- sented on this dimension to investors.

To conduct this analysis, we merge the subset of New Century data with the BlackBox-Equifax data set. This matching is done using numeric loan identifi- cation numbers, which are identical across the two databases. 15 Table IV , Panel

A displays the reports from this merge. As we observe, more than 93% of New Century loan files that misrepresented second liens to investors have simul- taneous second liens recorded in the bank’s internal database, in other words, New Century was aware of the existence of almost all second liens that ended up being misrepresented to RMBS investors as loans with no such liens. To the extent that practices in New Century are representative of other lenders in sub- prime market, these results suggest that lenders were aware that loans were being misrepresented on the dimension of second liens. Of course, though New Century was one of the largest subprime lenders, one might wonder whether these findings generalize. We turn to this question next.

15 The matching between the New Century data and the BlackBox-Equifax data set is perfect. After merging, we obtain 3,160 loans reported to investors as corresponding to owner-occupied

properties. Of these, our method identifies 148 loans (4.7%) as misrepresented nonowner occupants. In addition, 10,924 loans report no second liens to investors. Of these, our method identifies 1,279 loans (11.71%) as having a misreported second lien (see the Internet Appendix).

Asset Quality Misrepresentation by Financial Intermediaries

Table IV

Where Did Misrepresentation Occur? Evidence from New Century Loans and the Registry of Deeds

This table examines a sample of internal banking records for New Century and the Los Angeles County deeds records merged with records from the Black Box-Equifax database. The first row of Panel A examines the sample of New Century loans identified as having a misreported second lien and shows the percentage of these loans for which the second lien is correctly reported in the New Century internal data. The second and third rows of Panel A examine a sample of loans originated in L.A. County that misreported second liens to investors and show, respectively, the percentage of these loans that have a second lien reported in the deeds records and the percentage of these loans that have the same lender responsible for the first and second liens. Panel B shows the top three underwriters associated with the main lenders responsible for the misreported second lien loans in L.A. County. These lenders account for around 80% of lending in Los Angeles County. The numbers in parentheses show what percentage of loans of a given lender was sold by a given underwriter.

Panel A: Misrepresentations in the New Century Internal Database and L.A. County Registry

of Deeds

Percentage Count Loans with misreported second lien being reported as having a

93.70% 1,279 second lien in New Century data set Loans with misreported second lien being reported as having a

93.70% 2,978 second lien in the L.A. county deeds records Loan with misreported second lien has the same lender

99.67% 2,978 responsible for first and second liens

Panel B: Lenders and Underwriters Associated with Misreported Second Lien Loans in Los Angeles County

Lenders Top 3 Underwriters Countrywide

Countrywide (40.3%); Bear Stearns (8.9%); UBS (8.5%) WMC

Merrill Lynch (51.8%); Bank of America (29.8%); Morgan Stanley (16%) Lehman Brothers

Lehman Brothers (98.6%); Merrill Lynch (0.6%); Barclays (0.3%) New Century

Lehman Brothers (42.9%); Citigroup (25%); Goldman Sachs (15.2%) First Franklin

Lehman Brothers (94.6%); Bear Stearns (1.34%); HSBC (1.34%) MortgageIT

Lehman Brothers (84%); Bear Stearns (1.9%); Morgan Stanley (1.9%) DB Home Lending

Deutsche Bank (100%) Peoples Choice

Lehman Brothers (100%) Wells Fargo

Bear Stearns (31%); Lehman Brothers (22.6%); Citigroup (20.2%) NBGI

Deutsche Bank (32.5%); UBS (26.5%); Lehman Brothers (10.8%) Greenpoint

Merrill Lynch (42.1%); Morgan Stanley (36.8%); Greenpoint (4%) Resmae

Deutsche Bank (93.3%); J.P. Morgan (2.7%); Lehman Brothers (2.7%) Mandalay

Lehman Brothers (74.6%); Citigroup (23.7%); Goldman Sachs (1.7%) JP Morgan Chase

J.P. Morgan (93.6%); Lehman Brothers (4.3%); Countrywide (2.1%) Metrocities

Morgan Stanley (45%); Deutsche Bank (12.5%); Lehman Brothers (10%) Bank of America

Bank of America (89.5%); Bear Stearns (7.9%); RBS (2.6%)

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B. Evidence from Deed Records We next investigative if the findings in the previous section generalize be-

yond New Century. To do so, we merge the BlackBox-Equifax data set with the registry of deeds provided by First American. 16 Deeds records, which are main- tained by the local counties, document information every time a property is sold or a new mortgage is taken out by an owner using the property as collateral. The advantage of the deeds records data is that they include information on all of the loans for a given property that were legally recorded by the lenders as well as the lender’s name for each of these loans. This allows us to investigate whether the lenders were aware of the presence of second liens associated with misrepresented first-lien loans that they originated. We focus on Los Angeles County, the largest county in terms of the number of mortgages in our data.

Table IV , Panel A displays the results from this merge. Consistent with evidence from New Century, more than 93% of loans that we identify as misre- porting second liens have such liens present in the registry of deeds. Of these loans, 99.7% have the same lender responsible for both liens.

The deeds data also allow us to assess the relative role played by lenders and underwriters in second-lien misrepresentation. Figure 3 plots the distribution of misreported second-lien loans among the main lenders in Los Angeles County and the corresponding market share of these lenders in the second-lien mort- gage originations in this county. As can be seen, notorious subprime lenders such as Countrywide and New Century not only account for a substantial part of misrepresented second liens, but also have high market shares. For example, loans originated by Countrywide represent about 28% of misreported second- lien loans in our sample, while they account for about 15% of second liens in Los Angeles County. Finally, we observe misrepresentations among loans orig- inated by commercial banks such as Wells Fargo, Bank of America, and JP Morgan Chase, though their propensity to originate misrepresented loans is

smaller relative to their market share. Thus, Figure 3 suggests that both the lender and the underwriter may play a role in accounting for the propensity to misreport second liens.

Table IV , Panel B shows the top three underwriters associated with each of the lenders displayed in Figure 3 . Loans with misreported second liens are associated with a diverse pool of underwriters, including Lehman Brothers, Countrywide, Citigroup, Deutsche Bank, Merrill Lynch, Morgan Stanley, Bank of America, Bear Stearns, and Goldman Sachs. Moreover, most of the dominant originators of misreported second liens are associated with multiple underwrit- ers. For example, New Century loans in our sample were predominantly sold in pools underwritten by Lehman Brothers, Merrill Lynch, and Goldman Sachs.

Finally, Figure 3 and Table IV , Panel B also imply that, for more than 20% of misreported second-lien loans in the Los Angeles County sample, the lender

16 The deeds records were restricted to purchase mortgages originated between 2005 and 2007 for which we had information on zip codes, origination dates, and loan amounts. The records

were merged with the BlackBox-Equifax data set using these characteristics. Importantly, no information regarding second liens was used in this merge.

Asset Quality Misrepresentation by Financial Intermediaries

Figure 3. Second-lien misrepresentation across lenders in the Los Angeles county sam-

ple. The black bars present the distribution of misreported second-lien loans (in percent) among main lenders in the sample of misreported second lien loans originated in Los Angeles County. The sample is based on Black Box-Equifax data provided by the credit bureau, merged with Los Angeles County deeds records. The gray bars show the overall distribution of second-lien loans among 16 lenders in the Los Angeles County deeds records during 2005 and 2006.

and the underwriter are the same institution. This concerns loans originated and sold by Countrywide, Lehman Brothers, JP Morgan, and Bank of America. In such cases, it is hard to argue that these underwriters could not easily have accessed information on second liens that was, as we have shown, available at their own lending arms.

Overall, the evidence in this section confirms that the lenders of the first-lien loans were likely aware of the presence of simultaneous second liens since they themselves originated most of these second-lien loans. 17 In addition, at least in some cases, the underwriters were likely aware of these misrepresentations since they could have easily accessed such information. Similar inferences, using a different method, are obtained in Griffin and Maturana (forthcoming) .

17 Our results in Section IV.C indicate that loans with associated misreported second liens have interest rates that are lower than those charged on loans associated with truthfully reported second

liens. This may seem puzzling, given that lenders knew about the presence of second liens and both types of loans had similar (high) default risk. The lower rate on loans with misreported second liens may have allowed lenders and underwriters to present such loans as being of lower risk when selling them to investors. In addition, lenders could have compensated themselves for the true (higher) default risk of misreported loans by charging a higher markup on associated second liens. We do not have access to data that would allow us to further investigate such hypotheses.

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Figure 4. Misrepresentations across underwriters. This figure plots the percentage of loans with misreported second liens by underwriter along with a 95% confidence interval. Coefficients

result from adding underwriter fixed effects to the specifications in Table II . These levels are obtained by adding each underwriter fixed effect to the level of misrepresentation for the omitted category (Credit Suisse) with other covariates at their means. The dashed straight line shows the mean misrepresentation level.

C. Heterogeneity across Underwriters The results in Section V.B suggest that the identity of underwriters is im-

portant in accounting for misreporting propensity. We next investigate more systematically the heterogeneity across underwriters in their propensity to sell securities with misrepresented assets. We use specifications as in column (5)

of Table II with Misreported Second Lien as the dependent variable and with underwriter fixed effects in addition to the control variables. In Figure 4 , we plot the estimated level of underwriter misrepresentation, calculated using the underwriter fixed effects obtained from this regression and fixing other controls at their means, along with the 95% confidence interval. The omitted category in this figure is Credit Suisse, with 3.37% of loans in pools it underwrote having misreported second liens.

The figure shows significant heterogeneity across underwriters in the propen- sity to securitize misrepresented loans. Controlling for other loan character- istics, mortgages sold by Lehman Brothers are about five times more likely to be misrepresented on the dimension of second liens compared to loans sold by Credit Suisse. On the other hand, loans from pools underwritten by Merrill Lynch, Deutsche Bank, Nomura, and UBS have substantially lower

2661 misrepresentation levels. These findings suggest that the identity of the un-

Asset Quality Misrepresentation by Financial Intermediaries

derwriter helps account for significant variation in the extent of misrepresen- tation.

Importantly, our analysis also indicates that all underwriters had misrep- resentation levels significantly greater than zero. While it is hard to pinpoint whether underwriters knew about all of the misrepresentations in the pools they underwrote, information to uncover misrepresentations could have been collected—easily in many instances, as we show in Section V.B—by the under- writers during the acquisition and certification of mortgages.