Liar’s Loans, Mortgage Fraud, and the Great Recession

by: Thomas Herndon

July 09, 2017 |
Working Paper

Losses in private mortgage backed securities were at the epicenter of the financial crisis from 2007-2009. This paper by Thomas Herndon examines two features of mortgage fraud contributing to the financial crisis. It first accounts for total losses from foreclosure due to no/low documentation "Liar's Loans." It then estimates what portion of these losses can be considered excessive. Herndon finds that losses caused by fraud in Liar's Loans are substantial, prolonged, and concentrated in economically fragile neighborhoods. Specifically, Liar's Loans account for $345 billion of the $500 billion of total losses, $125 billion of which can be considered excessive.

Abstract

Losses in the market for private label residential mortgage backed securities (RMBS) were at the epicenter of the financial crisis from 2007-2008. Existing research has shown that a substantial portion of the poor performance of the loans securitized in this market was caused by fraudulent origination practices, and that these practices were misrepresented to investors who purchased securities based on these loans. However, to date no paper has estimated the effects of mortgage fraud on losses from foreclosure in this market. This paper fills this gap by 1) Accounting for total losses from foreclosure due to no/low documentation loans which were known colloquially within the industry as Liar's Loans, and 2) Estimating what portion of these losses can be considered excess from the perspective of the investor. Losses are considered excess in the sense that they were higher than the expected losses for investors, had the loan quality information disclosed to them been accurate, instead of fraudulent. I find that Liar's Loans account for roughly 70% of total losses, and 36% of losses in Liar's Loans can be considered excess. Projected to the level of the entire market, this implies that $345 billion of the $500 billion in losses from foreclosure are accounted for by Liar's Loans. Roughly $125 billion, or 25% of total market losses, can be considered excess losses caused by fraud in Liar's Loans.

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