Taking the Lie Out of Liar Loans: The Effect of Reduced Documentation on the Performance and Pricing of Alt-A and Subprime Mortgages

Abstract

We present a simple theoretical model of adverse selection when lenders allow reduced documentation. The model shows how reduced documentation attracts both riskier borrowers and larger size loans. We then empirically test implications of the model using stated income loans originated during the recent housing market run-up and collapse. After estimating the extent to which these loans have higher default rates than do fully documented loans, we develop a measure for the extent of income overstatement, providing results for both the Alt-A and subprime market segments. We also estimate that the incremental risk in these mortgages was priced at less than ten basis points.