Strict Loan Documentation Standards Will Help Prevent the Next Housing Bubble

One of the most egregious practices of the Great Housing Bubble was the fabrication of income by borrowers that was facilitated and promoted by originating lenders. Stated-income loan programs were widespread, and they were the cause of much of the uncertainty in the secondary mortgage market during the initial stages of the credit crunch in the deflation of the bubble. Basically, investors had no idea if the borrowers to whom they had lent billions of dollars were capable of paying them back.

Without proper documentation of income, investors lost all confidence in the secondary mortgage market. Stated-income loan programs were one of the first casualties of the credit crunch. These programs should be eliminated totally due to the inherent potential for fraud and the undermining of confidence in the secondary mortgage market stated-income loans create. If lenders can be sued based on the content of the loan documents, and if borrowers can be fined or go to jail for committing fraud or misrepresentation on loan documents, both parties have strong incentive to prepare these documents completely and correctly. Originating lenders will argue this adds to their costs and will result in higher application fees. The amount in question is very small, particularly relative to the dollar amount of the transaction. A small amount of additional expense here will provide huge benefits by assuring investors the borrowers to whom they are loaning money really have the income to pay them back. The benefit far outweighs the cost.

If such a law were passed, agency interpretation and court case precedents will end up defining adequacy in loan documentation. A single W2 does not establish a work history, but 2 years worth is probably excessive documentation. One of the most contentious areas will likely be documenting the income of the self-employed. In theory, the self employed must document their incomes to the US government either through Schedule C reports or corporate K-1s.

The argument the self-employed have traditionally made is that these documents understate their income. Since many self employed take questionable tax deductions, there is probably some truth to the claim that tax records understate their income; however, why should the self-employed get to have both benefits? If the self-employed had to use their tax returns as loan documentation, they probably would not be quite so aggressive in taking deductions. A new business without a tax return or with only one year of taxable receipts probably is not stable enough to meet standards of income necessary to assume a long-term debt.

The poor quality of loan documentation during the bubble was a mistake of originating lenders; therefore, in this proposal much of the burden of paperwork and liability for mistakes falls on the lenders. During the deflation of the bubble, lenders paid an enormous price for some of their lax paperwork standards, but much of the problem was also due to borrowers misrepresenting themselves in the loan documents.

There were instances where lenders encouraged this behavior, but in the majority of cases, the document fraud was perpetrated by the borrowers. The only recourse available to a lender is a civil suit as there are few criminal penalties associated with loan documentation and almost no enforcement. It can be very difficult and costly for lenders to pursue civil damages, and few lenders attempt it even when they have a strong case. To create a more balanced set of responsibilities, the borrowers must face criminal penalties for fraud and misrepresentation on loan documents. If borrowers know the lender can turn documents over to a prosecutor who will charge the borrower with a crime if they make false material statements, borrowers will be much less likely to commit these acts.

If loan documentation standards are tightened, much of the fraud in the system would disappear. Mortgage fraud inflated prices and reduced investor confidence in mortgage-backed securities. The inflated prices set the market up for a fall. The reduced investor confidence in mortgage-backed securities halted the flow of investment capital into the housing sector and exacerbated the decline of house prices. These problems would have been avoided if loan documentation standards were higher.

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