Study Reveals Misrepresentations in the RMBS Market

Following the financial crisis, a prevalence of misrepresentations in the residential mortgage backed securities (RMBS) market has exposed investors to greater risk, according to a recent ""report"":http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2215422 authored by university researchers Tomasz Piskorski, Amit Seru, and James Witkin.

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The researchers studied private-label RMBS sold in 2007 in search of misrepresentations regarding occupancy status and second liens. Private-label RMBS totaled about $2 trillion in 2007.

Overall, the researchers detected one of these two categories of misrepresentations in one out of every 10 loans.

When misrepresentations involving HELOCs are included, the rate jumps to 12.2 percent.

More than 27 percent of loans to non-owner occupants were categorized as for owner-occupants, and more than 15 percent of loans with second liens were miscategorized to hide the second lien, according to the findings.

While some might attribute these misrepresentations to low- or no-doc loans, the researchers explain they ""find significant extent of misrepresentation even when we focus on fully documented loans.""

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Misrepresentations of owner-occupancy are slightly lower for fully-documented loans, but the researchers found the opposite is true for second-lien misrepresentations, which are actually more prevalent among fully-documented loans.

The researchers clarify that these instances are not simply cases where ""buyers know less than the seller,"" but instead are cases in which ""buyers received false information on the characteristics of assets.""

In fact, lenders--seemingly aware of the discrepancies in loan facts and representations--often charged higher interest rates on loans with misrepresentations when compared to similar, accurately-represented loans. However, the heightened interest rates were not effective in covering the added risk, according to the study.

Importantly, the researchers state, ""We find that these misrepresentations have significant economic consequences.""

Loans containing misrepresentations of occupancy status have a default likelihood 9.4 percent higher than accurately-reported loans with otherwise-similar characteristics.

Loans with non-disclosed second liens have a 10.1 percent greater likelihood of default, according to the researchers.

""Because of their substantially worse performance, misrepresented loans account for more than 15 percent of mortgages that defaulted in our sample, a higher share than their proportion in the overall sample (about 10 percent),"" the researchers stated in their study.

The researchers conclude that industry regulation was not effective in preventing these detrimental behaviors in the industry.