Investors Understood Riskiness of Subprime Mortgage Backed Securities At Time Of Investing Before Recession And Before Real Estate Bubble Burst: Misrepresenation As To Loan Quality Was Not A Factor In Investor Losses: Atlanta And Boston Fed

Posted by Milton Recht:

From Federal Reserve Bank of Atlanta, Real Estate Research, "Asset-Quality Misrepresentation as a Factor in the Financial Crisis" by Paul Willen, senior economist and policy adviser at the Federal Reserve Bank of Boston, with help from Chris Foote, senior economist and policy adviser at the Federal Reserve Bank of Boston, and Kris Gerardi, financial economist and associate policy adviser at the Federal Reserve Bank of Atlanta:

The table comes from a Lehman Brothers analyst report from 2005 and provides forecasts of the performance of securitized subprime loans under varying scenarios for house prices. The bottom row of this table gives the "meltdown" scenario: three years of house-price declines at an annual rate of 5 percent. Under this scenario, Lehman researchers expected subprime deals to lose about 17 percent. In reality, prices fell 10 percent per year—double the rate in the meltdown scenario—yet the actual losses on subprime deals from that vintage are expected to come in around 23 percent.

Source :Source: Lehman Brothers, "HEL Bond Profile across HPA Scenarios," in U.S. ABS Weekly Outlook, August 15, 2005, via Federal Reserve Bank of Atlanta.

This table shows that investors knew that subprime investments would turn sour if housing prices fell. The "meltdown" scenario for housing prices implies cumulative losses of 17.1 percent on subprime-backed bonds. Such losses would be large enough to wipe out all but the highest-rated tranches of most subprime deals. The table also shows that investors placed small probabilities on these adverse price scenarios, a fact that explains why they were so willing to buy these bonds.

***Investors didn't really think of securitized subprime loans as less risky than they actually were. The documentary evidence repeatedly shows that investors understood the risk inherent in purchasing MBS that were backed by loans to people with bad credit histories. As the table shows, analysts expected 17.1 percent losses in the meltdown scenario. If we assume a 50-percent loss rate for each default, then overall losses of 17.1-percent imply that 34.2 percent of the loans—more than a third—would go to foreclosure. With the benefit of hindsight, we can see that the real problem for investors was not that they didn't think subprime borrowers would default if house prices fell. Rather, they didn't think house prices would fall in the first place.

Finally, it is important to stress that the quantitative effects of the level of misrepresentation found in the paper [Piskorski, Seru, and Witkin (2013)] are economically insignificant. Remember that the harm of misrepresentation for an investor arises because misrepresentation leads investors to under-forecast defaults. Quantitatively, the largest finding of misrepresentation reported by PSW is that 15 percent of purchase mortgages had some form of misrepresentation, and that the misrepresented loans were 1.6 times more likely to default. So, if an investor assumes that none of the loans were misrepresented, then a simple calculation shows that actual defaults are likely to come in about 1.09 times higher than forecast:

(0.85 x 1) + (0.15 x 1.6) = 1.09

This calculation implies that if a naïve investor forecasted, say, 8 percent defaults for a pool of subprime loans, then the true number would actually be 8 percent x 1.09 = 8.72 percent. But even this figure overstates the effect of misrepresentation, because it assumes that the investors had access to a "pure" data set that was uncontaminated by misreporting. In any case, for subprime loans originated in 2006, actual defaults came in about 40 percentage points over what was expected. In other words, even if we assume investors were completely naïve, misrepresentation can, at most, explain 0.72 percentage points out of 40.

We feel researchers should look elsewhere for an explanation for why investors lost so much money during the housing crisis. A good place to start is the belief by all actors in the drama— borrowers, Wall Street intermediaries, and investors—that housing prices could only go up. [Emphasis added.]