MORTGAGE LOAN COMPLIANCE®

Did Banks Make Bad Underwriting Decisions on Loans?

According to a research study conducted at the University of Michigan the underwriting on a subprime mortgage was not as strong if it planned to sell the loan to be securitized as opposed to keeping it in portfolio. Professor Amiyatosh Purnanandam, at the Ross School of Business, discovered that the more a bank participated in what he termed the "originate-to-distribute" market, the larger its charge-offs and defaults were.

It wasn't just an economic slowdown that caused the subprime mortgage crisis there was an "incentive problem" because the banks were not as diligent about the borrower if they planned to sell the loan. The loans more likely to default are not the ones banks kept and this divergence cannot be explained by differences in the geographic location of the property.

Furthermore, banks that relied more on demand deposits for funding were more likely to write better quality loans than those that relied on the financial markets. From a risk management perspective, Mr. Purnanandam said, regulators need to look at how a bank is funded and not just its actions. "The basic premise is that there was this perverse incentive," said Mr. Purnanandam. "The screening came down, and the banks were willing to lend to folks they otherwise would not have. We find a systematic pattern in that the banks that were originating and selling their mortgages are suffering disproportionately more."