Representations and Warranties: Why They Did Not Stop the Crisis

Abstract

During the run-up to the 2008 financial crisis, representations and warranties (contractual statements enforceable through legal action) may have given investors false assurance that mortgage loans were being properly underwritten. This assurance in turn may have contributed to overinvestment in mortgage-backed securities in two ways. First, the assumption that legally enforceable penalties associated with reps and warranties would deter lax underwriting may have led to less monitoring of these contracts than would otherwise have occurred. In turn, the lack of monitoring of actual underwriting practices enabled the spread of lax lending practices. The existence of these reps and warranties and the potential penalties associated with them did not deter lax underwriting. Paradoxically, after the fact, the reps and warranties were enforced and this enforcement contributed to a tightening of credit beyond historic norms. Post-crisis, lenders’ fears over put-back exposure caused them to scale back, particularly on government lending to creditworthy borrowers. The reps and warranties as used in mortgage lending in the run-up to the crisis were part of the procyclicality of lending, both in the easing and tightening phases of the lending cycle.

We suggest reforms to add to the deterrent value of reps and warranties. Particularly we suggest a shift to the countercyclical techniques including dynamic provisioning to increase the in terrorem effect of representations and warranties. Nonetheless such changes would be useless unless they were adopted throughout the lending industry, otherwise, just those entities with risky practices would increase their market share. And next time such entities are more likely to be thinly capitalized, as the lesson of capital exposure to legal risk has been learned, thus further reducing the deterrence effect of reps and warranties, going forward.