Misreporting of household income is an as-of-yet-understudied driver of the Financial Crisis. The basic argument is that some borrowers were able to obtain loans that they could not pay back, because they exaggerated their incomes on their loan applications. Two recent papers published in the Journal of Finance (1) document that some borrowers indeed misreported their incomes before the crisis, (2) find that borrowers who misreported were more likely to default post-crisis, even after controlling for observable borrower risk characteristics, and (3) explore why people might misreport.
Using loan applications from an unnamed U.S. Bank, Garmais (2015) first shows that loan applicants tended to round their incomes up to the nearest multiple of $100,000 in order to obtain larger loans. Then, he finds that (1) counties in which a greater fraction of loan applicants inflate their incomes have higher mortgage default rates, and (2) misreporting is more common in counties with a greater fraction of non-U.S. citizens, non-English speakers, and homeowners that probably have experienced negative home equity. (Misreporting is not correlated with the fraction of married or college-educated people.) From his second result, he deduces that misreporting is more common in areas with lower financial literacy and social capital. Overall, he concludes that financial illiteracy drives both misreporting (applicants misreport because they don’t know the value of their assets) and default.
Using loan origination documents from New Century Financial Corporation (New Century), Ambrose, Conklin, and Yoshida (2016) (ACY) largely corroborate Garmais’s findings; they find that applicants who could but did not verify income (1) exaggerate their incomes by a greater amount and (2) are more likely to default. (Income exaggeration is estimated by (1) regressing actual income on borrower characteristics for those with verified income; (2) predicting income for non-verified borrowers using the estimates from (1); (3) taking the difference.) Importantly, these results hold only for non-verified borrowers that submitted W-2 forms, not for self-employed borrowers. ACY argue that misreporting is borrower-specific, not common to people in the same industry.
Pros and Cons of Regulation
- Garmais: Limiting loans to applicants who report incomes right above multiples of $100,000 can exclude borrowers that misreport their incomes at the expense of excluding some creditworthy borrowers.
- ACY: Banning low-documentation loans (loans originated to borrowers with little documentation to verify, for example, income) can mitigate adverse selection at the expense of excluding creditworthy self-employed people, the target market for these loans. (Banks developed low-documentation (low-doc) loans in order to serve self-employed people, for whom income verification is costly and who are less likely to misreport, because poor reputations limit future credit availability. )