Taking the Lie Out of Liar Loans: The Effect of Reduced Documentation on the Performance and Pricing of Alt-A and Subprime Mortgages

Abstract:     
We examine stated income loans originated by Bear Stearns affiliates during the recent housing market run-up and market collapse. After showing the extent to which these loans have higher default rates than do fully documented loans after controlling for other risk factors, we develop a measure for the extent of likely income over-statement. We then simulate a loan origination process that rejects stated income loan applications with high degrees of likely over-statement and calculate the reduction in default rates that might have been achieved had such an algorithm been in place. Although reduced loan documentation appears to have been priced by lenders, our estimates suggest the risk was under-priced.

JEL Classification: G2

working papers series