Risky Mortgage Research Articles

Reexamining the 'Role of the Community Reinvestment Act in Mortgage Supply and the U.S. Housing Boom'

Concerns have lingered since the 2007 subprime crisis that government housing policies promote risky mortgage lending. The first peer-reviewed evidence of a causal effect was published by the Review of Financial Studies in a paper (Saadi, 2020) linking the crisis to changes in the Community Reinvestment Act (CRA) in 1995. A review of that paper, however, shows that it misrepresents the policy changes as having taken effect in mid-1998, 2.5 years after they were implemented. When the correct timing is used, a similar analysis yields no evidence of a relationship between CRA and riskier mortgage lending. Instead, the results are shown to reflect an unrelated confounding event, the first collapse of the U.S. subprime mortgage market following Russia’s debt default in August 1998.

The greening of lending: Evidence from banks’ pricing of energy efficiency before climate-related regulation

Shocks to energy prices can have a direct impact on homeowners’ disposable income, affecting their ability to repay their mortgage and the risk of default. Energy-efficiency increases the collateral value of a property as it can provide some protection not only against increasing energy prices but also against the upfront costs of having to comply with future tightening of environmental regulations. Anecdotally, driven by either risk management and/or corporate and social responsibility, lenders have increasingly included the energy transition risk factor in the lending risk when differentiating mortgage interest rates based on energy efficiency without the need for regulatory intervention. To gather evidence of the lenders’ pricing decisions, we study interest rates of mortgages originated in the UK prior to 2018, the period before recent regulation came in. We estimate standard pricing models using a unique dataset of 1.8 million mortgages. We find no evidence of lenders charging higher rates on riskier mortgages against energy-inefficient properties. Overall, our findings do not provide conclusive evidence that lenders took energy efficiency and hence the energy transition risk into account when setting interest rates. These results contribute to the debate on lenders’ risk management and the role of regulation in the greening of the economy.

Risky mortgages, credit shocks and cross-border spillovers

This paper describes a novel methodology of measuring risky and conservative mortgage credit using household survey data for 17 European Union countries and the United Kingdom. In addition, we construct time series for both types of credit and embed them into a global vector autoregressive (GVAR) model, so as to study how shocks to both variables affect domestic output and propagate across countries through cross-border banking exposures. The results show that a decrease in risky credit can have long-lasting positive effects on GDP, both in the originating country and its most exposed peers, while a fall in conservative credit is detrimental. In some geographies, negative shocks to both types of credit reduce output, a feature linked to the lower relevance of homeownership which implies that mortgage credit plays a less prominent role in the domestic economy.

Risky Mortgages and Macroprudential Policy: A Calibrated DSGE Model for Lithuania

Following the financial crisis of 2009 there was an emergence of macroprudential policy tools, as well as a need to model the macroeconomy and the financial sector in a coherent framework. This paper develops and calibrates a small open economy DSGE model for Lithuania to shed some light on the interactions between the macroeconomy and the banking sector, regulated by macroprudential policy. The model features housing market, and endogenous credit risk a la de Walque et al. (2010), whereby the household can default on mortgage repayments, what leads to housing collateral seizure. Foreign-owned banks, that are subject to risk-sensitive macroprudential capital requirements, take into account not only the mortgage default rate but also the cap on loan to value (LTV) ratio when making lending decisions. Using this mechanism, we show that while a more stringent LTV constraint reduced credit demand, it can also lead to an expansion in credit supply via lower credit risk. Therefore, a tightening of LTV requirement should result in only a slight reduction in mortgage lending, coupled with lower interest rate margins. The article compares the impact of the tightening of three macroprudential tools, namely, bank capital requirements, mortgage risk weights and LTV limit. We find that broad-based capital requirements, such as the counter-cyclical capital buffer, are less efficient in leaning against the housing credit cycle, because of a relatively large cost incurred on the firm sector.

Option compensation, risky mortgage lending, and the financial crisis

We examine how option compensation affects banks' risky mortgage origination and sale decisions before the financial crisis in 2008. We find that, in the period immediately before the financial crisis, option compensation has little impact on the riskiness of mortgages originated and is negatively associated with mortgage lenders' propensity to sell risky mortgages. The results are consistent with banks' incentives to maximize revenues from origination and servicing fees while managing risk exposure by adjusting the sale of risky mortgages. For identification, we use bank-year fixed effects and matched loan applications to control for both supply- and demand-side factors of mortgage lending. We find similar results when using the variation in option compensation generated by the implementation of FAS 123R.

Appraisal overvaluation: Evidence of price adjustment bias in sales Comparisons

AbstractHome appraisal came under scrutiny for contributing to the home‐price bubble and enabling the origination of risky mortgages that led to the post‐2006 foreclosure crisis. Subsequent regulations tried to minimize or eliminate conflicts of interest and improve valuations. Nonetheless, our study of appraisals completed in 2015 and 2016 find that appraisal bias still occurred. Our analysis delves into the underlying appraisal development to identify causes of appraisal bias. Contributing factors are that comps are generally higher valued than the subject property, and appraisers are more likely to comparatively adjust upward lower priced comps but less likely to adjust downward higher priced comps.

Risky Mortgages, Credit Shocks and Cross-Border Spillovers

This paper describes a novel methodology of measuring risky and conservative mortgage credit using household survey data for 18 European Union countries and the United Kingdom. In addition, we construct time series for both types of credit and embed them into a global vector autoregressive (GVAR) model, so as to study how shocks to both variables affect domestic output and propagate across countries through cross-border banking exposures. The results show that a decrease in risky credit can have long-lasting positive effects on GDP, both in the originating country and its most exposed peers, while a fall in conservative credit is detrimental. In some geographies, negative shocks to both types of credit reduce output, a feature linked to the lower relevance of homeownership which implies that mortgage credit plays a less prominent role in the domestic economy.

Non-Primary Home Buyers, Shadow Banking, and the US Housing Market

This paper studies the US housing market using a proprietary and comprehensive dataset covering nearly 90 million residential transactions over 1998–2018. First, we document the evolution of different types of investment purchases such as those conducted by short-term buyers, out-of-state buyers, and corporate cash investors. Second, we quantify the contributions of non-primary home buyers to the housing cycle. Our findings suggest that the share of short-term investors grew substantially in the run-up to the global financial crisis (GFC), which amplified the boom-bust cycle, while out-of-state buyers propped up prices in some areas during the recession. An instrumental variable approach is employed to establish a causal relationship between housing investors and prices. Finally, we show that the recent rise of shadow bank lending in the residential market is associated with riskier mortgages, and explore its implications for non-primary home buyers and its effects on house prices and rents.

Partial Deregulation and Competition: Effects on Risky Mortgage Origination

We exploit the preemption of national banks from state laws against predatory lending by the Office of the Comptroller of the Currency (OCC) as a quasi-experiment to study the effect of deregulation and its interaction with competition on the supply of complex mortgages. Following the preemption ruling, national banks significantly increased their origination of loans with prepayment penalties relative to national banks in states without anti-predatory-lending laws. We highlight a competition channel: in counties where OCC-regulated lenders had larger market shares, non-OCC-regulated lenders responded by increasing their supply of contracts with riskier features, such as deferred amortization, which were not restricted by the state anti-predatory-lending law. Non-OCC lenders were able to lure borrowers into these higher-margin contracts by increasing their appeal with teaser rates. This paper was accepted by Tyler Shumway, finance.

Problems and prospects of development of regulation methods of bank investment activity with derivative financial instruments

The financial crisis of 2007–2009, the effects of which the world is experiencing today, has had a very negative impact on the economies of many developed countries. There are several dozen causes that have led to a downturn in the economy and a start of distrust in the banking sector. Indeed, the financial crisis has been caused by the interaction of many factors, among which the main focus is the boom in the market for risky mortgages, the undervaluation of financial risks, excess free money, and the global imbalance of investment and savings. Credit derivatives, which became the main tool for enriching and obtaining cheap resources, have become the cause of massive bankruptcies of financial institutions and investors. But are these financial instruments designed to be used to hedge risks, on the contrary, are the impetus for the collapse of the banking sector? The emergence of the financial crisis should be blamed for inefficient methods of regulating the investment and credit activity of commercial banks, as well as the unfairness of their risk management, but not the credit derivatives themselves. The article discusses the causes of the 2007–2009 crisis, as well as the implementation of the Basel Committee–s recommendations to prevent recurrence of negative events. The necessity of improvement of regulation methods of investment activity of banks (related to derivative financial instruments) to maintain the necessary level of liquidity in case of unforeseen situation is established.

Debt Incentives and Bank Risk‐Taking

AbstractWe examine how executive pension and deferred compensation plans affect bank risk‐taking. We show that banks with more inside debt incentives are 5–6% less likely to approve risky mortgages. Using state individual tax rates as instruments, we show that the effect is likely to be causal. Further evidence shows that the effect comes mainly from executive pension plans. This result is robust and statistically significant after controlling for other potential reasons affecting mortgage origination and various fixed effects.

Debt Incentives and Bank Risk-Taking

We examine how executive pension and deferred compensation plans affect bank risk-taking. We show that banks with more inside debt incentives are 5-8% less likely to approve risky mortgages. Using state individual tax rates as instruments, we show that the effect is likely to be causal. Further evidence shows that the effect comes mainly from executive pension plans. This result is robust and statistically significant after controlling for other potential reasons affecting mortgage origination and various fixed effects.

Mortgage Lending Regulatory Arbitrage: A Cross-Sectional Analysis of Nonbank Lenders

We provide new insights about less regulated nonbank lenders, major originators of risky subprime mortgages prior to 2008. We document significant cross-sectional variations in lending practices and show that nonbank lenders who entered the industry via less-regulated states are associated with riskier loan originations. We also show that states with lower entry barriers have not significantly increased homeownership rates nor reduced poverty rates. Consistent with the traditional banking literature, our findings suggest that while low industry entry barriers encourage more risk taking by new financial institutions, they do not necessarily translate into long-term economic benefits.

Mortgage default decisions in the presence of non-normal, spatially dependent disturbances

We develop a flexible binary choice model for mortgage default decisions that incorporates neighborhood effects in the disturbances. The main advantage of the model lies in its performance in providing improved estimates of the probability of default for risky mortgage loans. In addition, it can be applied to portfolios with a high number of loans. Assuming mortgage decisions with spatially dependent disturbances, the proposed approach uses the generalized extreme value distribution to flexibly model the error terms. To estimate the model on a large sample size, we use a variant of the Geweke-Hajivassiliou-Keane algorithm. We apply the proposed model and its competitors to a large dataset on almost 300,000 mortgages in Clark County, which includes Las Vegas, over 2009–2010. The results show that our proposal greatly improves the predictive accuracy of identifying loans that will default. Moreover, the competitor models underestimate credit Value at Risk.

Risk Preferences Across Public and Private Sector Employees: Evidence from Mortgage Choices

Public sector employees have long been considered to be more risk-averse when compared with their private sector counterparts. Using data from mortgage applications, we offer novel evidence that casts doubt on this conventional view. We find little, to no, differences between public and private sector employees in terms of their risky mortgage choices. The findings are robust to accounting for potential bias from unobservables and testing alternative measures of mortgage riskiness.

Discussion

Discussion

What Caused the Tsunami of Recession to Financial Markets During the Period 2007-2008?

The credit crisis erupted in August 2007, with the failure of two Bear Stearns hedge funds, was a warning sign of what would follow. However, most firms did not take advantage of those signals to correct their weaknesses, and remained impassive to the new economic reality. Indeed, Lehman Brothers as one of them did not take the opportunity to reduce the risky mortgage portfolio, which in retrospect would prevent the future bankruptcy of the company. It was September 15, 2008 when Lehman Brothers filed for Chapter 11 bankruptcy and generated a tsunami of recession to financial markets. Some years after the collapse of Lehman Brothers, financial markets still remain as vulnerable as it were on the eve of collapse. The paper seeks to address the exact factors that led to the bankruptcy event of Lehman, to examine whether it could have been prevented and make recommendations for going forward.

Does the Financial Reporting Transparency of Securitization Affect Bank Lending Decisions?

This study examines the effect of financial reporting transparency for securitization on banks’ lending decisions. I hypothesize that transparency affects bank lending decisions through its effect on bank stakeholders’ ability to monitor and discipline bank risk-taking. Using loan-level data from the Home Mortgage Disclosure Act database and FASB securitization accounting pronouncements as transparency shocks, I find that securitizing banks originate riskier mortgages following accounting pronouncements that allow more opacity and less risky mortgages following pronouncements that enhance transparency. Moreover, I show that manager-shareholder alignment, regulatory constraints, and market discipline moderate the effect of transparency on bank lending decisions.

The real estate crash of 2007-8 as a systemic failure

This article considers the 2007-8 real estate market as a complex adaptive system. The article begins with a discussion of its perception of a system. Given that definition, system elements are reviewed. Agents include mortgage holders, lending institutions of a variety of forms, insurers, and regu latory agencies. The focus is on the US with some comparison to the UK and Canada. This system was affected by economics with heavy governmental influence. A market that had been highly stable for decades reacted very negatively to the influences of financial engineering seeking to take advantage of expedient opportunities. The complex interactions of financial and governmental actors led to the apparent (and most likely temporary) disappearance of many paper fortunes, as well as leading to the demise of some established banking institutions and foreclosure of many homes in certain areas. Conversely, Canadian real estate markets had less relaxation of regulation, and experienced fewer risky mortgages. The evolution of the real estate system from a systems perspective is described, with analysis of interactions among actors.

Mortgage risks, debt literacy and financial advice

A limited understanding of mortgage contracts and the risks involved may have contributed to the outbreak of the 2007–2008 financial crisis. We developed a special questionnaire relating mortgage loan decisions to financial knowledge and financial advice. Our results demonstrate that homeowners appear to be well aware of mortgage risks. Large loans relative to home value are perceived as riskier, as are loans with large mortgage payments relative to income and loans linked to investment vehicles. Homeowners with riskier mortgages indicated that they could encounter financial problems should house prices or their income decline. Homeowners with relatively low debt literacy are more likely to take out traditional mortgages with principal repayments over the maturity of the loan. Riskier mortgages are more prevalent among homeowners with a better understanding of loan contracts. Financially less sophisticated homeowners consulting mortgage brokers, too, hold riskier mortgages.