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1.3.4.2 Underwriting with Little Consideration of Risk

As described earlier regarding yield spread premiums, securitization, and the secondary market,286 pricing was often explicitly not based upon risk. Instead brokers and other originators focused on writing loans for as high a price as possible. They did so because their commission was based on how much the actual price exceeded the (purported) risk-based price set by the lender.287 The risk of default was not a factor in how brokers and other originators priced the mortgage. Lenders priced loans at what the market would bear and relied on market segmentation to increase the cost of credit (and returns to investors), rather than to fairly price risk.288 Unsurprisingly, lenders who substituted higher interest rates for underwriting often failed to identify who was risky and who was not, with correspondingly high default and foreclosure rates.289

In addition, during the years prior to the foreclosure crisis, the subprime mortgage market and even prime mortgage lenders for many years preferred “no-doc” and low-documentation loans, written at an interest rate markup, to fully underwritten loans.290 In some cases, lenders’ underwriting guidelines required them to redact any income information that made it into their files.291 Lenders sometimes would underwrite loans based on the initial teaser rates and not the monthly payment levels that were sure to exist within a year or two.

Footnotes

  • 286 {286} See § 1.3.2, supra.

  • 287 {287} See Ch. 7, infra (a more detailed discussion of mortgage broker compensation and yield spread premiums).

  • 288 {288} See, e.g., Richard R. W. Brooks, Credit Past Due, 106 Colum. L. Rev. 994, 1003–1006 (2006) (discussing fringe lending’s lack of reliance on traditional measures of creditworthiness and the manner in which fringe lending’s failure to report credit histories of borrowers can trap borrowers, especially African-American borrowers, in expensive fringe credit); Diana B. Henriques & Lowell Bergman, Mortgaged Lives: A Special Report; Profiting from Fine Print with Wall Street’s Help, N.Y. Times, Mar. 15, 2000, at A1 (subprime mortgage lenders charge borrowers with “A” credit the same rates and fees they charge borrowers with “D” credit); Sumit Agarwal, John C. Driscoll, Xavier Gabaix, & David Laibson, The Age of Reason: Financial Decisions Over the Lifecycle 8–9 (Feb. 11, 2008), available at http://ssrn.com (older and younger borrowers pay more for credit than midlife borrowers in home equity loans primarily because they underestimate the value of their homes and apply for loans with a higher loan-to-value ratio than needed; lenders conduct their own appraisal of the value of the property and re-price the loans higher if the consumer overestimated the value, but do not re-price the loans lower when the consumer underestimates the value of the home). Cf. Howard Lax, Michael Manti, Paul Raca & Peter Zorn, Subprime Lending: An Investigation of Economic Efficiency, 15 Hous. Pol’y Debate 533 (2004) (one percentage point of the risk premium paid by subprime borrowers could not be explained by the borrowers’ credit risk attributes).

  • 289 {289} See, e.g., Susan E. Barnes, Patrice Jordan, Victoria Wagner & David Wyss, Standard & Poor’s, Standard & Poor’s Weighs in on the U.S. Subprime Mortgage Market 12 (Apr. 5, 2007) (subprime loans with no documentation associated with early payment default); Michelle A. Danis & Anthony Pennington-Cross, Fed. Reserve Bank of St. Louis, Working Paper No. 2005-022A, Delinquency of Subprime Mortgages 20 (2005), available at http://research.stlouisfed.org (“Loans with limited documentation also are delinquent and default more frequently than full documentation loans. The impact for loans with no documentation is even larger.”); Morgan J. Rose, Fed. Reserve Bank of Chicago, Predatory Lending Practices and Subprime Foreclosures—Distinguishing Impacts by Loan Category 23 (Dec. 2006), available at www.chicagofed.org (finding in a review of Chicago subprime foreclosures that low or no documentation led to significant increases in the rate of foreclosure for refinance loans but had no statistically significant relationship to foreclosures on purchase loans); Ellen Schloemer, Wei Li, Keith Ernst & Kathleen Keest, Ctr. for Responsible Lending, Losing Ground: Foreclosures in the Subprime Market and Their Cost to Homeowners 21 (Dec. 2006), available at https://www.responsiblelending.org (loans originated with less than full documentation in 2003 had a 63.7% higher risk of foreclosure).

  • 290 {290} Seventy percent of subprime loan pools rated by Standard & Poors in the first half of 2005 had less-than-full documentation. Ruth Simon, James R. Hagerty & James T. Areddy, Housing Bubble Doesn’t Scare Off Foreigners, Wall St. J., Aug. 24, 2005, at 1, 7. See 74 Fed. Reg. 44,522, 44,540, 44,541 & n.53 (July 30, 2008) (discussing prevalence of stated-income loans and incentives for originators to make these loans, including inflated loan amounts, inflated interest rates, and ease of origination; recognizing that stated-income loans did not accurately predict risk or ability to repay); Interagency Guidance on Nontraditional Mortgage Product Risks, 71 Fed. Reg. 58,609, 58,614 (Oct. 4, 2006) (discussing and cautioning against increasing reliance on “reduced documentation”). See also California v. Ameriquest (Cal. Super. Ct. Alameda Cty. Mar. 21, 2006) (complaint ¶ 10H), available at http://ag.ca.gov (Ameriquest fabricated income and assets); McGlawn v. Pennsylvania Human Relations Comm’n, 891 A.2d 757 (Pa. Commw. Ct. 2006) (broker created false income information for low-income borrowers); Susan E. Barnes, Patrice Jordan, Victoria Wagner & David Wyss, Standard & Poor’s, Standard & Poor’s Weighs in on the U.S. Subprime Mortgage Market 12 (Apr. 5, 2007) (20%–30% of pools rated by Standard & Poors contain subprime loans with no documentation and piggyback loans); U.S. Gov’t Accountability Office, Pub. No. GAO 09-741, Home Mortgages: Provisions in a 2007 Mortgage Reform Bill (H.R. 3915) Would Strengthen Borrower Protections, But Views on Their Long-Term Impact Differ 19 (2009), available at www.gao.gov (increasing percentages of subprime loans had less than full documentation, ranging from 27% in 2000 to nearly 60% in 2007). Cf. Terwin Mortgage Trust Asset-Backed Certificates, Series Tmts 2004-11he, Terwin Advisors L.L.C., Seller, Merrill Lynch Mortgage Investors, Inc., Depositor, Prospectus Supplement dated Sept. 27, 2004, to Prospectus dated June 18, 2004, at S-39 (stating that seller only knows the underwriting guidelines used for approximately 32% of the loan pool).

    Prime, subprime, and Alt-A mortgage loans are defined in § 2.4, infra.

  • 291 {291} Comments of the National Consumer Law Center, et al. to the Board of Governors of the Federal Reserve System [Docket No. R-615] Regarding Proposed Regulations Relating to Unfair Trade Practices in Connection with Mortgage Lending 10 (Apr. 9, 2008), available at www.nclc.org.