Extent of Second-Lien Misrepresentation, Loan Performance,
Interest Rate
Panel A presents OLS estimates from regressions in which the dependent variable takes a value of one if the mortgage ever defaults (ever goes 90 days past due on payments) in the first two years since origination, and zero otherwise. Panel B presents OLS estimates from regressions in which the dependent variable is the mortgage’s interest rate at origination. Column (1) shows the results with Misreported Second Lien as a control variable. The sample used in these regressions consists of loans that reported to investors no presence of second lines. Columns (2) to (4) show the results when we extend the sample to include loans that reported second liens to investors. These specifications use Misreported Second × CLTV ࣙ 100, Misreported Second × CLTV < 100, Reported Second × CLTV ࣙ 100, and Reported Second × CLTV < 100 as control variables, where the excluded category comprises loans that truthfully reported no second liens. The CLTV term (computed from credit bureau data) in these interactions takes a value of one if the loan has a CLTV ratio in the appropriate range, and zero otherwise. “Other Controls” include origination variables reported to investors used in Table III such as FICO, interest rates, LTV ratios, and the origination time fixed effects. Squared and cubed terms for FICO and LTV ratios are also included to account for potential nonlinear effects. The estimates are in percentage terms; standard errors are in parentheses. *p < 0.10, **p < 0.05, and ***p < 0.01.
Panel A: Mortgage Default and Misreported versus Reported Second Lien Misreported second
Misreported Second × CLTV < 100
(0.2776) (0.4841) Reported Second × CLTV < 100
(0.1192) (0.9360) Misreported Second × CLTV ࣙ 100
(0.1934) (1.3816) Reported Second × CLTV ࣙ 100
(0.1091) (2.3059) Other controls
Yes Yes State fixed effects
Yes
Yes
Yes Yes SEs clustered by state
No
No
No Yes Number of loans
No
No
1,109,250 1,109,250 Percent default
14.58 17.10 17.10 17.10 Percent misrepresented
Panel B: Interest Rates at Origination and Misreported Versus Reported Second Liens Misreported second
Misreported Second × CLTV < 100
(0.00994) (0.0325) Reported Second × CLTV < 100
(0.00426) (0.0392) Misreported Second × CLTV ࣙ 100
(0.00689) (0.0848) (Continued)
Asset Quality Misrepresentation by Financial Intermediaries
Table III—Continued Panel B: Interest Rates at Origination and Misreported Versus Reported Second Liens
(3) (4) Reported Second × CLTV ࣙ 100
(0.00389) (0.125) Other controls
Yes Yes State fixed effects
Yes
Yes
Yes Yes SEs clustered by state
No
No
No Yes Number of loans
No
No
1,109,250 1,109,250 Mean interest rate
6.654 6.654 Percent misrepresented
So far we show that mortgage defaults on loans with misreported second liens are significantly higher than on similar loans that are truthfully disclosed as not having such liens. We now run another comparison—we compare mortgage defaults on loans with misreported second liens to similar loans with truthful reports on the presence of such liens. To this end we extend our sample to include loans that reported second liens to investors and examine the relation- ship between subsequent delinquency of a loan and whether the loan has a truthfully reported second lien, a misreported second lien, or no second lien.
Given the well-established nonlinearity in the relationship between debt and defaults, we need to not only control for the presence of a misreported second lien but also its size. For loans with a reported second lien, we already know the CLTV. For misreported second liens, we construct the correct CLTV by using the original balance of the first mortgage reported to BlackBox, the second lien balance reported to Equifax, and the original home value. We then consider the differential impact of a higher level of debt on default by constructing four dummy interaction variables: Misreported Second × CLTV > = 100, which takes a value of one if the loan has a misreported second lien and a CLTV greater than or equal to 100, and zero otherwise; Misreported Second × CLTV < 100, which takes the value of one if the loan has a misreported second lien and a CLTV less than 100, and zero otherwise; and Reported Second × CLTV ࣙ 100 (Reported Second × CLTV < 100), which takes a value of one for loans with
a truthfully reported second lien and CLTV greater than or equal to (less than) 100. The next three columns in Table III , Panel A repeat the analysis with these four interaction terms as our variables of interest. Relative to the first column, we expand the sample to include loans backed by properties reported as having a second lien. The specifications differ in whether we include state fixed effects (column (3)), and clustering of standard errors at the state level (column (4)).
Consistent with prior literature (e.g., Lee, Mayer, and Tracy ( 2013 )), loans with reported second liens are much more likely to default than those without such liens, and the effect is nearly twice as large when the CLTV is greater
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Figure 2. Misrepresentation and loan cumulative default rates. This figure shows the es- timated cumulative default rates in the first two years since origination at the loan level based on second-lien status, holding constant at their overall sample mean all other observables used in
Table II such as FICO. The y-axis is the cumulative percentage of loans that were 90 days past due at least once.
than or equal to 100. More important for our purpose, we find similar patterns for loans with misrepresented second liens as well. In particular, loans with misrepresented second liens are significantly more likely to default relative to loans with no second liens (i.e., loans that misrepresented loans are pretending to be). This effect is again about twice as large when the CLTV is greater than or equal to 100.
The results reported so far give us a static picture of the nature of subse- quent defaults on misrepresented loans. We now investigate how the impact of misreported second-lien status on default varies over a loan’s lifetime. We use monthly data to estimate the transition probability that a given loan goes
90 days past due on its payments in its first two years since origination. We include a set of fixed effects representing the first eight quarters of a loan’s life, which allows us to estimate the dynamic pattern of defaults. Figure 2 plots the cumulative delinquency rate of loans over time, holding all other observables constant at the overall sample mean. Loans with either a misre- ported or a reported second lien tend to default at significantly higher levels than loans truthfully reported as having no second lien over all time periods. Moreover, consistent with our prior results, loans with misreported second liens have similar default patterns to loans with truthfully reported second liens.
Asset Quality Misrepresentation by Financial Intermediaries
C. Second-Lien Misrepresentation and Mortgage Rates Above we have shown that, holding all characteristics reported to investors
equal, misrepresented loans are more likely to default ex post when compared to similar loans with no misrepresentation. We now investigate whether lenders might have been aware of these misrepresentations and accordingly charged a higher interest rate to compensate for the higher default risk of misrepresented loans.
In Table III , Panel B, we examine the relationship between misrepresented second liens and mortgage interest rates using a specification similar to equa- tion (1), but now the dependent variable is the mortgage interest rate. The covariates used in the regression include variables known to be related to the
risk of the loan, such as FICO, LTV, and whether the loan is an ARM. 13 Relative to the first column, the last three columns expand the sample to include loans backed by properties reported as having a second lien. The difference across the last three specifications results from whether we also include state fixed effects (column (3)), and cluster standard errors at the state level (column (4)).
The results in column (1) show that loans with misreported second liens have interest rates that are only slightly higher than loans with truthfully reported no second liens. Moreover, columns (2) to (4) show that the interest rates on misreported second liens are significantly lower than those that are truthfully disclosed as having a second lien. This holds for both loans with CLTV <100 (12 bps higher for loans with truthfully reported second liens versus almost the same rate as loans with no second liens for misreported loans) and for loans with CLTV ࣙ 100 (29 bps higher for loans with truthfully reported second liens versus only nine bps higher for loans with misreported second liens).
Recall from Section IV.B that default rates on loans with misreported second liens are significantly higher than on loans with no such liens, while similar to loans with truthfully reported second liens. Thus, taken together the evidence in Table III and the results in Section IV.B suggest that, though loans with misrepresented second liens had higher interest rates than loans with no sec- ond liens, this interest rate markup was lower relative to loans with similar
default risk, that is, loans with correctly reported second liens. 14 Overall, the evidence suggests that lenders were at least partly aware of the higher risk of misrepresented loans because they charged higher interest rates on these
13 The other covariates have the expected signs (e.g., indicators associated with higher risk, such as low or no documentation, were correlated with higher interest rates). Regardless of the
controls and type of specification, the qualitative and quantitative nature of the results reported in the table remains the same.
14 To give an alternative perspective on these results, we also analyze the distribution of vari- ation in interest rates across loans grouped by their second-lien status, controlling for other risk
characteristics (see the Internet Appendix). Consistent with our earlier results, these distribu- tions indicate that loans with truthfully reported second liens receive on average higher interest rates than loans that truthfully report not having a second lien. More importantly, loans with misreported second liens have origination interest rates that are only slightly higher on average than those that truthfully report not having a second lien.
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loans. This raises the question of where in the securitization process did these misrepresentations occur. We investigate this question next.