Alex Constantine - March 8, 2013
"... Investors were unknowingly buying assets that were actually far riskier than what they were paying for. ... current regulatory measures, like the 2010 Dodd–Frank Wall Street Reform and Consumer Protection Act enacted as a response to the 2008 financial crisis, are not specific enough to combat this type of fraud. ..."
A newly published paper by Booth professors examines how investment banks misrepresented important loan information, contributing to the 2008 financial crisis.
A new paper co-written by a Booth professor reveals how frequently investment banks misrepresented important information about the quality of loans sold to investors during the housing bubble that contributed to the 2008 financial crisis. The paper, authored by Finance Professor Amit Seru and Columbia Business School’s Tomasz Piskorski and James Witkin, was released last week.
In their research, Seru and his colleagues sought to understand the underlying factors that led to the financial crisis in the hopes that the insight could lead to more effective regulation by the federal government, Seru said. They found a notable prevalence of fraud.
To detect the potential presence of fraud, the researchers compared what was reported to investors about the loans to the actual characteristics of the loans.
They found two types of misrepresentation: mortgages that were labeled as owner-occupied primary residences when they were actually unoccupied and mortgages labeled as first loans that were actually concealed second or third loans. As these types of mortgages and loans are more susceptible to default in the event of a sudden drop in income, investors were unknowingly buying assets that were actually far riskier than what they were paying for.
The study found that approximately one in 10 assets from all “reputable” banks—like Lehman Brothers and JP Morgan—had one of these misrepresentations, and that those loans were 150 percent more likely to default than other loans with otherwise similar characteristics. The authors note that this is actually a conservative estimate, as there could be other types of misrepresentation that were not addressed in this research, and that it is likely that more than 10 percent of such assets were misrepresented.
Seru said that current regulatory measures, like the 2010 Dodd–Frank Wall Street Reform and Consumer Protection Act enacted as a response to the 2008 financial crisis, are not specific enough to combat this type of fraud.
“[Legislators say] we have to make sure banks are not too big. We have to impose taxes. These are very good broad principles, but it’s time to get specific.”