Borrower Misrepresentation and Loan Performance

Misrepresentations by borrowers are associated with grave loan outcomes. Residential mortgage borrowers who reported personal assets just above round number thresholds were more than twice as likely to experience subsequent delinquency. Significantly more borrowers report assets just above these thresholds than just below. Both these findings are true only for applicants with unverified assets, which is consistent with reported asset targeting by misrepresenting borrowers. Misrepresentation has the greatest impact on delinquency for properties that later become potentially underwater. Misrepresentation is most common for mortgages that result in a high debt load and in neighborhoods in which refinancings are relatively frequent. JEL Codes: G21, G32, D23 Correspondence to: Mark Garmaise, UCLA Anderson, 110 Westwood Plaza, Los Angeles, CA, 90095. E-mail: mark.garmaise@anderson.ucla. edu. I thank the U.S. financial institution for providing the data. I am grateful for comments from Zhaohui Chen, Tomek Piskorski, Amit Seru and an anonymous referee and from seminar participants at the SFS Cavalcade, the Summer Real Estate Symposium, the WFA, the Peruvian SBS and UCLA. Risk assessment and control are core functions of financial institutions. In any setting with asymmetric information, one central concern is misrepresentation risk, the risk that other parties will provide false or misleading information. Allegations of misrepresentation in financial transactions have become quite common, but there is relatively little evidence clearly identifying it and quantifying its extent. How serious is the impact of misrepresentation? What can be done to detect or deter it? Providing insights into these questions can help the support the long-run stability and performance of financial institutions. In this paper I offer an empirical description of personal asset misrepresentation by a bank’s mortgage borrowers and show that it had grave consequences for loan outcomes. Using a regression discontinuity approach, I show that borrowers who claimed a personal asset level just above a round number threshold (e.g., $203,000) were more than twice as likely to experience subsequent delinquency as those who claimed personal assets just below the threshold (e.g., $198,000). I also find that many more borrowers reported assets above, rather than below, these thresholds. Both these results are consistent with the idea that some borrowers misreported their personal assets to be above round number thresholds and that these borrowers were much more likely subsequently to become delinquent. The impact of misrepresentation on delinquency is much greater for loans that later became potentially underwater (i.e., loans for which the home equity may have become negative). The severity of misrepresentation risk varies with the loan terms and the location of the underlying property, suggesting that financial institutions may be able to take steps to shield themselves from its effects. Information collection and risk mitigation by banks have been the themes of a broad stream of research. Some of this work has focused on a bank’s sourcing of soft information and its incorporation into loan provisions (Stein 2002, Petersen and Rajan 2002 and Berger et al. 2005). Recent intra-bank studies have analyzed the role of hierarchy (Liberti and Mian 2009) and the impact of moral hazard on within-firm communication (Hertzberg, Liberti and Mian 2010). In this paper, I present mortgage