Housing Bubble and Fraud
Preet Bharara, Manhattan’s U.S. attorney, is a man on a mission. Not satisfied with the historical conviction of former McKinsey managing director Raja Gupta for insider trading, he quickly moved to investigate mortgage fraud. Earlier this month he sued Wells Fargo and last week Bank of America for mortgage fraud. Some people regard these prosecutions as politically motivated. After all, high-profile prosecutions of financial crimes were the launching pad for Rudolph Giuliani’s, Eliot Spitzer’s, and Andrew Cuomo’s political careers. Yet, political ambitions might not the worst of all possible motivations. Suing large corporations and powerful people can be very costly, both in terms of time and reputation. They can hire the best lawyers to fight back and can more easily hurt a prosecutor’s career.
In fact, the question is not whether Preet Bharara’s indictments are politically motivated, but whether the Obama’s DOJ lack of indictment activity is. Five years after the beginning of this crisis and millions of mortgage defaults later, American voters are still struggling to understand whether the mortgage crisis was just the unfortunate outcome of a brutal adjustment in house prices or the result of a major bank fraud. Two recent academic papers help us shed some light on this question.
The first one (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2021507) tries to assess whether predatory lending was the cause of the large increase in mortgage defaults we experienced in 2007-2010. It does so by exploiting a natural experiment generated by Illinois legislators. In 2006 they introduced mandatory counseling in selected Chicago neighborhoods, to repeal it only 20 weeks after it was introduced. Predatory lending is commonly defined as lending that imposes unfair and abusive loan terms on borrowers. The immediate effect of this mandatory counseling was to discourage almost half of the loans. While many good loans might have been prevented, it is safe to say that probably almost all the predatory ones must have been curtailed. What was the effect on later defaults? The authors find that defaults were reduced by one third. Thus, predatory lending was clearly not the only factor, not even the biggest one in the housing crisis. Yet, it might have been an important contributing factor.
While the paper calls it predatory lending, the better term would be crazy lending, because it is not clear that the banks were forcing these loans on ignorant consumers, and not the other way around. In fact, the reason why the program was suspended only 20 weeks after its beginning was that the local population complained with the legislators for the negative effects this law had on the availability of mortgages. So many of those borrowers were very willing victims.
This first paper, however, does not deal directly with the Bank of America’s case. To try to answer the question of whether banks willingly lied in their securitization documents I had to read a preliminary version of a paper by Piskorski, Seru, and Witkin. They compare the characteristics of securitized mortgages that were disclosed to the investors at the time of sale with characteristics of these loans as reported in the banks’ proprietary datasets. They find that more than 6% of mortgage loans misreport occupancy status of the borrower (whether he was an owner or an investor) while 7% of loans do not disclose the presence of second liens.
Users of large databases may be unimpressed by these numbers. Any database contains errors. Are these errors large enough to be worrisome? And how do we know that the banks knowingly misrepresented this information, rather than just being sloppy n reporting it? The court will have to answer this question beyond reasonable doubt. Yet, the authors provide some interesting evidence in this direction. They show, for example, that the misrepresentation is correlated with higher defaults down the line. Thus, it does not seem to be a random mistake, but a purposeful one.
Yet, even in this case the effect seems to be reasonably small. Yes, probably there was fraud and the banks need to be sued, but the housing bubble and the subsequent crash was not driven by fraud or abusive practices. In fact, the fraud and the abusive mortgage terms seem the outcome of the euphoria surrounding the housing bubble, rather than its cause. To explain this euphoria economists have to work harder than lawyers.