Turning a Blind Eye: Wall Street Finance of Predatory Lending

Abstract:     
Today, Wall Street finances up to eighty percent of subprime home loans through securitization. The subprime sector, which is designed for borrowers with blemished credit, has been dogged by predatory lending charges, many of which have been substantiated. As subprime securitization has grown, so have charges that securitization turns a blind eye to financing abusive loans. In this paper, we examine why secondary market discipline has failed to halt the securitization of predatory loans.

When investors buy securities backed by predatory loans, they face a classic lemons problem in the form of credit risk, prepayment risk, and litigation risk. Securitization exacerbates all three risks by unbundling the mortgage process, giving rise to adverse selection. In theory, the lemons problem should cause investors to flee the market for subprime mortgage-backed securities or demand a risk premium commensurate with the worst quality loans. Instead, securitization allays adverse selection concerns by structuring transactions so that risk-averse investors receive their agreed-upon return without needing to screen out predatory loans. In addition to pricing, the secondary market uses structured finance and deal terms, instead of filtering, to manage credit, prepayment, and litigation risk. Furthermore, structured finance provides incentives to securitize predatory loans. Voluntary due diligence could help ameliorate the problem, but those efforts remain sparse. To alter this perverse incentive structure, we propose legislation to impose a duty on secondary market assignees of subprime home loans to investigate and police predatory lenders.

Keywords: subprime, predatory lending, securitization, lemons problem

JEL Classifications: D18, D62, D82, G21, G28, J7, K2, K22, L85

Accepted Paper Series