Poor Underwriting is Contagious

Last year, University Financial Associates (UFA) introduced the idea of contagious misbehavior and their effect on the default rate. UFA utilized that data to take a closer look at how poor underwriting spreads within the mortgage sector in a report titled “Race to the Bottom?” released on Wednesday. According to the report, lenders tend to be pressured to lend more aggressively if competing lenders relax standards.

Data from UFA shows that in the years leading up to the financial crisis in 2007, lenders sought after more and more ways to lend to marginal buyers. The “No-doc” and NINJA (no income, no job, no assets) loans increased as lenders fought to outdo each other by selling more loans, thus the quality adjusted index of default rose for multiple lenders. As one lender began to its questionable underwriting practices, others followed suit in order to keep up competitively.

“Our research shows there is compelling evidence that poor underwriting is indeed contagious. The underlying data provides evidence of most private-label lenders’ relaxed underwriting standards which spread through the industry during the 2000s,” said Dennis Capozza, Professor Emeritus of Finance in the Ross School of Business at the University of Michigan, and a founding principal of UFA. “Data for other loan types like autos and mobile homes have similar contagion events before default crises. The challenge for regulators is to identify these contagion events and act to control them before a crisis develops.”

UFA’s original research from last year showed that political corruption in an area correlated to some extent with excessive defaults. If misbehavior can have an effect on separate sectors, it is easy to see how aggressive lending from one lender can lead to aggressive competition to another.

To view the full report and more from UFA, click here.