Buyer, Beware?

July 27, 2010

Mortgage fraud and misrepresentation is taking center stage in the clean up of the mortgage mess.

Fannie Mae and Freddie Mac have been pushing back record numbers of loans to their customers after reviews turned up irregularities and failures to follow underwriting guidelines.  In an effort to help the GSEs recover funds from lenders who bent the rules, their Conservator, theFederal Housing Finance Agency (FHFA) has sent subpoenas to more than 60 lenders demanding documents that the GSEs need to make their case. In a recent NY Times article, Gretchen Morgenstern summarizes the questionable behavior of securities issuers in passing on poor loans to investors, even when they knew the loans didn’t meet investor expectations or advertised quality.

I was asked recently by someone looking into the crisis if I could quantify the varying degrees of culpability for fraud among buyers and sellers.  I can’t.  I do believe there are borrowers out there who knowingly fudged their own numbers to qualify for a loan.  Investors, especially, had plenty of incentive to bend the truth to get the money to buy the property they planned to flip.  

But I believe far more damage was done by creditors and sellers of loans. As house prices rose, the pool of eligible borrowers shrank.  Yet tons of capital was competing for mortgage backed assets.  This combination provided plenty of incentive for the systematic weakening of underwriting and ultimately the faking of underwriting to keep the fees coming. The originate-to-sell model that had everyone passing the risk up the line while taking a cut fostered an environment that discounted loan quality to boost loan quantity.  And the further up the chain these loans went, the less incentive there was to look too closely.

We know that there were investors who saw behind the curtain and called out the weak standards.  Michael Lewis’ The Big Short is a marvelous narrative about just these folks.  And as the NY Times piece points out, many of those packaging and selling faulty loans knew too, they just didn’t care.

The recently passed financial reform bill contains some important new restrictions that should put the lid on this for the near future.  But what ultimately is emerging from this wreckage is a story mostly about bent sellers and middlemen.

Buyer, beware, indeed.