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Saturday, September 29, 2007

What's Really Wrong With Stated Income

by Tanta on 9/29/2007 06:10:00 PM

I had pretty much decided that I had said all I have to say about stated income loans with this post, but now that, per Chevy Chase, IT'S BACK!, I'm going to say one more thing. Then I'm done.

Apologists for stated income always bring us back to this so-called "classic" loan involving a self-employed borrower who "needs" a stated income loan because income is hard to verify or, you know, the tax returns don't "show the whole picture." This is never, really, actually, an argument about why stating rather than verifying income is necessary, although it pretends to be. It's really about why people with volatile income or a preference for not paying taxes on their income should get the "benefit" of financing on the same terms as wage-slaves and people who don't cheat on their taxes. That argument will end just before the sun freezes, so I'm not at all interested in participating in it.

My big problem with stated income lending has never really been about the wisdom or importance or lack thereof of making mortgage loans to the self-employed. My problem has to do with elemental safety and soundness of lenders, in a way that may not be obvious, so I'm going to hammer it for a bit.

Let us take the "classic" stated income hypothetical loan: the borrower is self-employed, has been for years and years, is buying a house, and has some trouble verifying income. Imagine that everything else about the loan is just groovy: high FICO, big down payment, lots of cash reserves after closing, scout badges out the wazoo. I'm not "stacking the deck" here. This looks like a super loan in all respects, except that question about whether there is sufficient current income to service the borrower's debts, or reason to believe that current income will last long enough to get past payment three or so.

We can make this loan in one of two ways:

1. We go "stated income." The borrower provides no tax returns, and just happens to state income sufficient to produce a debt-to-income ratio of 36%, which just so happens to be the maximum traditional cut-off for "acceptable risk."

2. We go "full doc," and the underwriter does a complete income analysis. In writing, on the sacred 1008 (the Underwriting Transmittal in the file), the underwriter fully discusses the business and its cash flow, noting that a 24-month averaging of income is producing a DTI of 68%. However, the underwriter believes that cash flow trend is positive, that there are documented reasons to believe it will continue, that the borrower has sufficient personal cash assets not needed for the business to supplement income for debt service, and hence this high DTI is justified. The 1008 of course is countersigned by a senior credit officer, because it is an exception to normal lending rules--the DTI is too high--and also because we are doing our required Fair Lending monitoring, making sure that the exceptions we make are made fairly, not just to rich white folks or folks in certain zip codes, but to anyone who qualifies for them.

Either way, it's the same loan, but Number 1 was more "efficient." Same risk, right?

Wrong. The default risk of the individual loan is only one risk. There's another huge looming risk created in Number 1 that we keep ignoring.

What happens if the loan performs just fine for a while? Well, if it's held by a financial institution, that institution will be subject to periodic safety and soundness and regulatory compliance examinations. One major point of those exams is to make sure the institution is holding sufficient reserves and capital against its loan portfolio. Among other things, an examiner might look at some reports of loan activity. And on reports, Number 1 looks like a low-risk loan with a 36% DTI. Number 2 catches someone's attention.

But, you say, wouldn't an examiner's attention be caught by the fact that Number 1's "doc type code" is stated, making it the kind of apparent higher risk worth a look at the loan file? Well, not if we started this whole thing by having assumed that there's no additional risk in stated income if other loan characteristics are good enough. The whole circular argument--stated is OK for OK loans--means that this will be considered one of those "not high risk" stated income loans, because all the other data points (FICO, DTI, LTV, etc.) look good.

The odds, therefore, that Number 2 would get further review are high, because it stands out as an exception loan with a high DTI. The odds that Number 1 would get further review are no better or worse than random.

And for any other purpose, such as counterparty due diligence, investor approval, um, servicer ratings, etc., that relies on aggregated data, Number 1 isn't going to make the institution's average DTI look worse, while Number 2 will. It matters if you write enough of those loans.

And what does the institution risk by having an auditor or examiner take a look at the file for Number 2? Why, the risk is that the auditor or examiner will not agree with that analysis, or will find the documentation unconvincing, or will be troubled by an apparent over-willingness to make exceptions or something. This is how the game is played: the loan shows up on some examination problem report, management is forced to respond with a memo defending its underwriting practices, and possibly even more loans get reviewed as the examiners seek potential evidence that whatever they don't like about that file is part of a pattern. Any stray skeletons you might have in your loan file closet (and everyone has a few loans they rather wish they hadn't made, or had handled better when they made them) get dragged out onto the conference room table.

Number 1, in other words, doesn't attract scrutiny. And what happens if it actually goes bad?

Well, with Number 1, it's "clearly" the borrower's fault. He or she lied, and we can pursue a deficiency judgment or other measures with a clear conscience, because we were defrauded here. We can show the examiners and auditors how it's just not our fault. The big bonus, if it's a brokered or correspondent loan, is that we can put it back to someone else, even if we actually made the underwriting determination. No rep and warranty relief from fraud, you know.

With Number 2? There is no way the lender can say it did not know the loan carried higher risk. Of course, higher-risk loans do fail from time to time, and no one has to engage in excessive brow-beating over it, if you believed that what you did when you originally made the loan was legit. If you're thinking better of it now, at least with Number 2 you have an opportunity to see where your underwriting practice or assumptions about small business analysis went wrong.

For anyone using loan servicing databases to research risk factors, of course, Number 1 might cause the conclusion to be drawn that stated income is a risk independent of other loan features. Number 2 might cause the conclusion to be drawn that 68% DTIs just don't work out well on the whole. You could, of course, go back and update the system with Number 1, after it fails and your QC people get around to finding the true income numbers, so that the database will show the true ratio of 68%, but that gets you to the catching-examiner-attention problem above.

And what about Fair Lending compliance? Insofar as a lot of stated income lending is just a way around having to make a formal exception to your lending policies, it's a good way of hiding certain patterns in terms of who you let get away with what. We do ourselves no good by thinking that the current environment--in which any marginal risk can get a stated loan--is the permanent environment. Structural ways to avoid showing your exception patterns invite abuse.

I have said before that stated income is a way of letting borrowers be underwriters, instead of making lenders be underwriters. When I say make lenders be lenders, I don't mean let's not regulate them. I have no problem with regulatory examinations; far from it. I am someone whose signature (usually, in fact, as that second sign-off) has appeared on exactly these kinds of loans, and whose butt has been on the line for them. We all face having loans we approved go bad; the world works that way. What the stated income lenders are doing is getting themselves off the hook by encouraging borrowers to make misrepresentations. That is, they're taking risky loans, but instead of doing so with eyes open and docs on the table, they're putting their customers at risk of prosecution while producing aggregate data that appears to show that there is minimal risk in what they're doing. This practice is not only unsafe and unsound, it's contemptible.

We use the term "bagholder" all the time, and it seems to me we've forgotten where that metaphor comes from. It didn't used to be considered acceptable to find some naive rube you could manipulate into holding the bag when the cops showed up, while the seasoned robbers scarpered. I'm really amazed by all these self-employed folks who keep popping up in our comments to defend stated income lending. It is a way for you to get a loan on terms that mean you potentially face prosecution if something goes wrong. Your enthusiasm for taking this risk is making a lot of marginal lenders happy, because you're helping them hide the true risk in their loan portfolios from auditors, examiners, and counterparties. You aren't getting those stated income loans because lenders like to do business with entrepreneurs, "the backbone of America." You're not getting an "exception" from a lender who puts it in writing and takes the responsibility for its own decision. You're getting stated income loans because you're willing to be the bagholder.

And no, this doesn't particularly do much for my assessment of your business acumen. Frankly, I'd rather see your tax returns and your P&L and hear your story about how investments in the business you have made, with the intent to grow it wisely, have limited your income or made it highly variable, than to see you volunteer to risk prosecution for fraud because, you know, you really need to buy a house. Do you do business with people like that all the time? Are you typically attracted to deals that are claimed to be perfectly legitimate, except that it's important not to fully disclose certain facts to certain parties? Does that maybe explain some of your accounts receivable problems and your pathetic cash flow? It certainly seems to be explaining some lenders' cash-flow problems at the moment.

This isn't just an issue for regulated depositories. All those claims by securities issuers and raters about how we had no idea that gambling was going on in this joint are directly comparable. The tough news for the self-employed "respectable" borrower is that I don't care if you're individually willing to play bagholder: you can't afford to underwrite that collective risk. We have a major credit crisis that's proving that.