In recent years, the subprime market became a race to the bottom. Because of the capital markets’ voracious appetite for securities backed by subprime mortgage loans, originators engaged in intense competition to produce volume. This emphasis on quantity over quality resulted in a lowering of underwriting standards and an increase in risky loan features. As a result, beginning as early as 2005 and continuing throughout 2006 and the first half of 2007, lax underwriting standards prevailed and long-standing lending norms were routinely ignored. In addition, as demonstrated by the States’ Ameriquest Mortgage Company investigation and settlement, loan origination fraud became more common, particularly inflated appraisals and stated income fraud.

This view is bolstered by industry studies. For example, the rating agency Fitch recently reviewed a small sample of loans that defaulted within the first 12 months after securitization and concluded that fraud played a major role. Fitch concluded that “poor underwriting quality and fraud” may account for as much as 25% of the defaults.⁹ Fitch further commented that, “[t]here was the appearance of fraud or misrepresentation in almost every file.”¹⁰

Weak or non-existent underwriting coupled with high levels of origination fraud combined to produce loans that had no reasonable prospect of being repaid. Rather, these loans were originated based on the assumption that housing appreciation would continue indefinitely and that when borrowers ran into trouble, they would refinance or sell. While this approach worked for a few years, when the inevitable leveling off and decline in housing prices began, the refinance option was cut off. Because many loans were originated without regard for the borrowers’ ability to pay, only in the last year have we begun to see the disastrous results of this reckless lending.

Servicers are being asked to clean up the mess caused by reckless origination practices. While the servicing system was well-designed to deal with traditional payment defaults due to life events such as a job loss or divorce, the servicing system was not designed to re-underwrite a massive number of loans that are defaulting due to failures in loan origination, such as loans originated with built-in payment shock, failures by lenders to assess a borrower’s ability to repay, or hidden fraud associated with inflated appraisals or falsified incomes.

In our meetings, the State Working Group found much common ground with the intentions and the initiatives of mortgage loan servicers. Servicers agreed that it was in their interest and in the interests of secondary market investors who own securities backed by

9 Up to 25% of Subprime Losses Blamed on Fraud, Inside B&C Lending, November 30, 2007, at 5.

10 Id.

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