Cambridge Finance Workshop Series are usually held on Thursdays during term time. The workshops are an opportunity for those working in finance to present their latest results or papers.
Brent W. Ambrose is the Smeal Professor of Real Estate, Director of the Institute for Real Estate Studies, and Director of the Smeal College Ph.D. Program at the Smeal College of Business at the Pennsylvania State University.
Credit Rationing, Income Exaggeration, and Adverse Selection in the Mortgage Market
Abstract
We examine the role of borrower concerns about future credit availability in mitigating the effects of adverse selection and private information in the mortgage market in the run-up to the foreclosure crisis of 2007 to 2010. We develop a simple theoretical model to motivate our empirical analysis. Our results show that the majority of additional risk associated with ``low-doc'' mortgages is due to adverse selection on the part of borrowers who could verify income, but chose not to. We provide evidence that these borrowers, who tend to live in relatively low-income neighborhoods, are more likely to inflate or exaggerate their income. Our paper contributes to the debate concerning income overstatement and mortgage credit expansion by extending the analysis of borrower income misrepresentation and adverse selection observed across mortgage types and borrower employment status. By focusing on differences in employment status, we show that the majority of adverse selection and income falsification is confined to a specific borrower group that was never intended to utilize the low-documentation product. Thus, our results show that broad policies designed to eliminate activities associated with excesses in mortgage originations during the housing boom may have unintended consequences.