What it means
Normally, a lender asks for proof before lending: payslips, tax returns, bank statements and employer letters. A liar loan, formally known as a stated income or low-documentation loan, skips most of that.
The borrower simply states their income on the application and the lender accepts it, usually in exchange for a higher interest rate. These products originally served a narrow group, such as self-employed people with irregular income that was hard to document.
But in the years before 2008, they spread widely in some markets, as lenders competed for volume and often sold the loans on to investors. Because the lender expected to pass the risk to someone else, the incentive to check was weak.
When house prices stopped rising and borrowers struggled to pay, many of these loans defaulted at high rates. Since the stated incomes had often been inflated, the borrowers could not afford the payments from the start.
The losses spread through mortgage-backed securities held by banks and investors worldwide. Regulators responded with reforms.
In the United States, rules introduced after the crisis require lenders to make a reasonable, good-faith determination that the borrower can repay, which effectively ended most stated income mortgages for home purchases. Other countries tightened their affordability checks too, and the details depend on local law.
For a finance manager, the lesson is about incentives and verification. Where the party making a decision does not bear the loss, checks tend to weaken.
This applies to supplier credit, customer credit limits and expense approvals as much as to mortgages, and good controls require documented evidence for important numbers.
In practice
Real-world examples.
Example
A mortgage broker encourages an applicant to round up his income on a form because the lender will not ask for proof. The loan is approved quickly, but the borrower struggles with the payments when his hours are cut.
Example
A bank's risk team audits a portfolio of older low-documentation loans and finds that many borrowers' stated incomes are much higher than the amounts shown on their tax filings. The bank increases its loss provisions to reflect the higher risk of default.
Example
An investor in a mortgage-backed security reads the pool description and notes that a large share of the loans were low-documentation. She decides the risk is too high and sells the position before problems appear in the pool's performance.
Formula
Calculation
Debt-to-income ratio = (Annual debt payments / Annual gross income) x 100%
Worked example: a borrower applies for a mortgage. Monthly payments on the new mortgage and existing debts total $3,000, which is $3,000 x 12 = $36,000 a year. The borrower states an income of $120,000, but the true verified income is $80,000.
Stated ratio = $36,000 / $120,000 = 0.30, or 30%, which looks comfortable.
Actual ratio = $36,000 / $80,000 = 0.45, or 45%, which is much higher and would fail many lenders' standards.
The overstatement of $40,000 in income turns an apparently safe loan into a risky one. Because no documents were checked, the lender never saw the true ratio until the borrower began missing payments.Case study
Seen in the real world.
Lakeshore Mortgage is a fictional lender that expanded rapidly by offering stated income loans with no document checks. It approved 2,000 loans averaging $250,000, a total of $500,000,000, and sold most of them to investors within weeks.
Sales staff earned commissions on volume, so they had no reason to question the figures on application forms. When property prices fell, 12% of the loans went into default, and investors demanded that Lakeshore buy back the poorest loans.
The buyback bill of $60,000,000 exceeded the company's capital, and it collapsed. This is an illustrative story, but it captures the way weak verification and volume incentives combined to cause real losses.
Watch out
Common mistakes.
- Thinking liar loans are only the borrower's fault. Lenders, brokers and investors who encouraged or ignored unverified claims also bore responsibility, and many faced losses and penalties.
- Believing stated income lending is always illegal. It was legal for years in many markets, and it can still exist in limited forms, but misstating income on an application can be fraud.
- Assuming the risk only affects the lender. When loans are bundled and sold, the risk spreads to investors, and widespread defaults can disturb the whole financial system.
Questions
People also ask.
Why were liar loans popular?
Borrowers with irregular income found them convenient, and lenders earned higher fees and rates. Rising house prices hid the risk for a time.
What replaced them?
Stricter ability-to-repay rules and standard verification of income, assets and employment. In the United States, qualified mortgage standards set out what lenders must check.
What should a borrower do if self-employed?
Keep clear records such as tax returns and bank statements, or use lenders who specialise in self-employed borrowers and verify income in alternative, documented ways.
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