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Published in Providence Business News (5/12 – 5/18/08)

As Federal and State officials sift through the ashes of the subprime mortgage collapse, there is understandably a lot of finger-pointing going on.

And a lot of the fingers are being pointed at Stated Income Loans.

The CEO of a company working to recover mortgage fraud losses asserted “this is not a sub-prime crisis�this is a stated income crisis”.

And even the U.S. Comptroller of the Currency has weighed in, saying that Stated Income Loans should be the exception rather than the rule.

Yet in 2006, according to the Comptroller, half of all subprime loans were Stated Income Loans.

So just what are Stated Income Loans, and are they responsible for the subprime mortgage crisis? The first question is much easier than the second.

Stated Income Loans are a type of reduced documentation loan. In a full documentation loan, a borrower submits proof of employment, assets, and income, including W-2 statements and copies of two years of income tax returns.

In the Stated Income Loan, the borrower states his income, but does not provide documentation proving that income. The lender generally agrees not to verify income in exchange for a higher interest rate or fees, although the lender does verify the borrower’s employment and assets.

Because the borrower merely states but does not prove his income, the Stated Income Loan has won the sobriquet of “The Liar’s Loan”.

And that is not bestowed without some substantiation. The Mortgage Asset Research Institute, which assists lenders in combating fraud, claims that a study of 100 Stated Income Loans determined that 90% of borrowers overstated income by five percent or more, and almost 60% overstated income by 50% or more. If that study is indicative of industry-wide patterns, these loans may be better known as Over-Stated Income Loans.

Of course, lying on a mortgage loan application is a crime punishable by fines and jail time.

Some of the frauds have been spectacular. A husband and wife team obtained a $1.8 million mortgage from Bear Stearns, falsely documenting themselves as the owners of a successful marketing company earning $50,000 a month, with assets of $3 million. That was a bit of a stretch since the borrower was a telephone technician earning $105,000 a year with $35,000 in assets. However, he did not let that slow him down. In the same week he obtained the $1.8 million mortgage, he fraudulently obtained another mortgage for $1.9 million. Fortunately for Bear Stearns, he applied to BankFirst for the other mortgage.

It’s cases like this, and statistics about over-stating income, that have resulted in demands for reining in Stated Income Loans. U.S. Senator Charles Schumer has introduced legislation in the Congress that would effectively eliminate them.

The Comptroller of the Currency has said that the Stated Income Loan “is too great a temptation for misrepresentation and, in its most extreme form, outright fraud”.

While there may be legitimate concerns about Stated Income Loans, there are also substantial benefits from such loans, which arose because many self-employed people could not meet the standards for a full documentation loan, and therefore could not get a mortgage, even though they had sufficient income and credit-worthiness.

For example, self-employed individuals may have significant sources of cash income, such as from tips, or they may have significant deductions for non-cash expenditures (such as depreciation) reflected on their tax returns that understate their actual income, which would disqualify them for full documentation loans.

Many employees also have problems with full documentation loans, where income verification looks backward (last two years) and not forward. As Wharton Professor Jack Guttentag notes, the low-paid medical resident just starting a lucrative practice will not benefit from his greatly increased income under a full documentation loan but would under a Stated Income Loan. The person recently receiving a substantial raise would encounter the same problem.

It is more likely that the subprime mortgage collapse was caused by a coincidence of factors, including as Professor Guttentag has suggested, the end of housing price appreciation, speculative purchases and refinancings, borrowers making commitments they could not honor, and “disaster myopia” – the inability of lenders to fully appreciate looming problems because things have been so good for so long. Add to that list looser underwriting standards and the willingness of lenders and brokers to process shaky loans since they were being sold to the secondary market, relieving lenders of risk.

Markets themselves may be responding to the excesses. At least one mortgage insurer has announced it will not insure Stated Income Loans. Some lenders are getting out of the Stated Income Loan business, and others are ratcheting up the conditions for obtaining Stated Income Loans. Such loans have always carried a higher price for the riskiness of not verifying income, and that price differential may be rising as well.

Maybe this is something government should stay out of.

Recall Washington’s efforts to fix the federal savings and loan industry in the late 1980s. The net result: nearly half of S&Ls closed their doors, S&L’s share of the mortgage market declined by fifty percent, and taxpayers were stuck with a nearly $130 billion tab for “fixing” the problem.

If Washington says it is going to solve the subprime mess and fix the Liar’s Loan, it may not be telling the truth.

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