Credit Booms and Lending Standards: Evidence from the Subprime Mortgage Market

Abstract

This paper links the U.S. subprime mortgage crisis to demand‐side factors that contributed to the rapid expansion of the U.S. mortgage market. We show that denial rates were relatively lower in areas that experienced faster credit demand growth and that lenders in these high‐growth areas attached less weight to applicants’ loan‐to‐income ratios. The results are robust to controlling for supply‐side factors, including house price appreciation, mortgage securitization, and other economic fundamentals, and to several robustness tests controlling for endogeneity. The results are consistent with the notion that a relaxation of lending standards, triggered by an increased demand for loans, contributed to the boom and the ensuing crisis, together with other supply‐side explanations. These findings shed new light on the relationship between credit booms and financial instability.

Securitization and credit quality in the European market

“…There is significant evidence from the United States suggesting that banks that resorted more intensively to securitization activity in the years prior to the crisis relaxed their lending standards more aggressively than other institutions (Dell'Ariccia, Igan, & Laeven, 2012;Keys et al, 2011;Nadauld & Weisbach, 2012;Purnanandam, 2011). There is also related evidence linking securitization activity and increases in bank risk-taking (Goderis, Marsh, Vall Castello, & Wagner, 2007;Haensel & Krahnen, 2007;Instefjord, 2005), and systemic risk (Brunnermeier & Sannikov, 2014;Krahnen & Wilde, 2008;Michalak & Uhde, 2013;Wagner, 2007).…”

“…As some banks may be more active in the securitization market, it could be that those loans granted to borrowers by securitization active banks may be more likely to be securitized. Also securitization active banks may also be more likely to lower their screening standards (e.g., Dell'Ariccia et al, 2012;Keys et al, 2011;Nadauld & Weisbach, 2012;Purnanandam, 2011) and lax screening standards can generate an effect that is observationally indistinguishable from the effect of reduced ex post monitoring (Wang & Xia, 2015). In short, there may be fundamental differences between borrowers of securitization active and non-active banks.…”

The Role of Lending Practices on the Foreclosure Crisis: Evidence from Indiana and Ohio

“…For example, Mian and Sufi (2009) find that areas where loan denial rates declined by more than predicted based on borrower quality and characteristics experienced more rapid increases in house prices. Dell'Ariccia, Igan, and Laeven (2008) show that the MSAs where houses appreciated at a faster rate also experienced lower loan denial rates. This effect was much more pronounced in subprime mortgage markets relative to prime mortgage markets.…”

Securitization as a response to monetary policy

“…In this study, we build a partial equilibrium model and examine how banks adjust their asset portfolio, particularly by using MBS, in response to changes in monetary policy. The literature identifies two motivations for banks to securitize loans: relaxation of capital constraints (also known as demand for liquidity, Altunbas, Gambacorta, & Marques, 2009;Berger & Udell, 1993;Carlstrom & Samolyk, 1995;Cerasi & Rochet, 2014;DeMarzo & Duffie, 1999) and transferring portfolio risks to third parties in the financial market (Dahiya, Puri, & Saunders, 2003;Dell'Ariccia, Igan, & Laeven, 2012;Marsh, 2006). These two motivations are considered as benefits of issuing MBS, which we model explicitly.…”