Unfortunately, lenders miscalculated. “Limited doc” loans rapidly became the worstperforming sector of the nonagency MBS market.<sup>23</sup> The most spectacular failures were due to borrower fraud, particularly fraudulent appraisals (which misrepresented the LTV ratio) and "silent second" mortgages (i.e., second mortgages taken out simultaneously with the first mortgage, unbeknownst to the first lien mortgage lender, thus misrepresenting borrowers’ debt ratios and equity contribution). However, even mainstream lenders experienced much higher-than-anticipated losses on their limited doc portfolios, for several reasons:

- a. Adverse selection: The near-total lack of borrower disclosure attracted genuinely weak borrowers, rather than creditworthy ones who failed to qualify on a technicality.<sup>24</sup>

- b. Payment-induced borrower default: Most limited doc loans were ARMs because they were more likely to have to remain in the lender's portfolio; and the combination of deep teaser rates and rising interest rates caused payments to increase dramatically through the late 1980s.<sup>25</sup>

- c. Vanishing equity: When the real estate market turned sour, prices on distressed properties dropped much faster than the overall average, which rapidly deflated the equity cushion.<sup>26</sup>

- d. Search for additional volume: Originators and investors, seeking to retain and grow profitable fee-based business volume moved progressively down market to ever less-qualified borrowers.

# **Not Understanding New Mortgage Designs**

**Investors in the subprime and jumbo markets  lacked data to evaluate the performance of new mortgage instruments such as option ARMs, 2/28 ARMs, and others.**<sup>27</sup> These newer loan instruments cannot be evaluated with data for other loan designs in rising property markets. It has been suggested that loans with adjustable rates are a big part of the problem, but such loans are not new. Adjustable rate mortgages have been a part of the U.S. market for some time, but more to the point, they have been the main type of mortgage in countries like Canada and the U.K. for some time without major disruption. What was unknown (due to a heavy reliance on historical data) was how a slowdown or turndown in the housing market would affect defaults of ARMs with

> 23 “Mortgage Defaults Start to Spread: New Data Show That Nontraditional Loans Are Beginning To Haunt Borrowers With Midlevel Credit; Prime Still Fine,”  Wall Street Journal, March 1, 2007; Page D1

> 24 - “What is ALT- A... Anyway?” Andrew Davidson Company, September 2004, <u>http://www.ad co.com/newsletter/Sept04/Sept04.htm</u>

> 25 “Defaults on Some `Alt A' Loans Surpass Subprime Ones,” Bloomberg News, July 24, 2007

> 26 “Pimco Says Subprime Woes May Spread to Alt-A, Jumbo (Update1),”  Bloomberg News, March 16, 2007.

27 An adjustable-rate mortgage that allows the borrower to choose among several payment options each month. The options typically include: 1) a traditional payment of principal and interest based on a set loan term; 2) an interest-only payment; and 3) a minimum (or limited) payment which may be less than the amount of interest due that month and may not pay down any principal. Borrowers that make limited payments may incur negative amortization of principal.

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