Subprime Study: Banks Made Poor Underwriting Decisions on Loans Being Sold

A bank's underwriting on a subprime mortgage was not as strong if it planned to sell the loan to be securitized as opposed to keeping it in portfolio, a study from a professor at the University of Michigan Ross School of Business found. According to Amiyatosh Purnanandam, the more a bank participated in what he termed the "originate-to-distribute" market, the larger its charge-offs and defaults were after 2007. These loans were more likely to default than the ones banks kept and this discrepancy cannot be explained by differences in the geographic location of the property. Therefore, it wasn't just the economic slowdown that caused the subprime mortgage crisis, it was an "incentive problem" because the banks weren't as discerning about the borrower if they planned to sell the loan. "The basic premise is that there was this perverse incentive," said Mr. Purnanandam. "The screening came down, and the banks were willing to lend to folks they otherwise would not have. We find a systematic pattern in that the banks that were originating and selling their mortgages are suffering disproportionately more." Furthermore, banks that relied more on demand deposits for funding were more likely to write better quality loans than those that relied on the financial markets. From a risk management perspective, Mr. Purnanandam said, regulators need to look at how a bank is funded and not just its actions.