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Giovanni Dell’Ariccia, Deniz Igan, and Luc Laeven∗
First Version: December 2007
This Draft: February 2008
Abstract
This paper studies the relationship between the recent boom and current delinquencies in the subprime mortgage market. Specifically, we analyze the extent to which this relationship can be explained by a decrea in lending standards that is unrelated to improvements in underlying economic fundamentals. We find evidence of a decrea in lending standards associated with substantial increas in the number of loan applications. We also find that the underlying market structure of the mortgage industry mattered, with larger declines in lending standards being associated
with increas in the number of competing lenders. Finally, incread ability to curitize mortgages appears to have affected lender behavior, with lending standards experiencing greater declines in areas with higher mortgage curitization rates. The results are consistent with theoretical predictions from recent financial accelerator models bad on asymmetric information, and shed some light on the underlying caus and characteristics of the current crisis in the subprime mortgage market. JEL classification codes: G21, E51
上海市政府副秘书长Keywords: credit boom, lending standards, mortgages, subprime loans, moral hazard, financial accelerators
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∗ The authors are all at the IMF Rearch Department (Financial Studies Division). Dell’Ariccia and Laeven are also at the CEPR. We would like to thank Stijn Claesns, Simon Johnson, Rebecca McCaughrin, and minar participants at the International Monetary Fund for helpful discussions and/or comments on an earlier version of this paper. Mattia Landoni provided outstanding rearch assistance. The views expresd in this paper are tho of the authors and do not necessarily reprent tho of the IMF, its Executive Board, or its Management. Address for correspondence: Giovanni Dell’Ariccia, IMF, 700 19th Street NW, Washington, DC 20431 USA. E-mail: Gdellariccia@imf.
I. I NTRODUCTION
Recent events in the market for mortgage-backed curities have placed the U.S. subprime mortgage industry in the spotlight. Over the last decade, this market has expanded dramatically, evolving from a small niche gment to a major portion of the overall U.S. mortgage market. Anecdotal evidence suggests that this trend was accompanied, at best, by a decline in credit standards and excessive risk taking by lenders, and, at worst, by widespread outright fraud.1 Indeed, the rapid expansion of subprime lending, fueled by financial innovation, loo monetary conditions, and incread competition, is en by many as a credit boom gone bad. Yet, few attempts have been made to empirically link lending standards and delinquency rates in the subprime mortgage market to its recent rapid expansion. To our knowledge, our paper is the first to do so.
How does the recent increa in delinquency rates relate to the boom? How did lending standards change over the expansion? How did changes in local market structure and financial innovation affect lender behavior during the boom? What was the role of monetary policy? To answer the questions, we u data from over 50 million individual loan applications combined with information on local and national economic variables.
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Reminiscent of the pattern linking credit booms with banking cris, current mortgage delinquencies appear related to past credit growth. In particular, delinquency rates ro more sharply in areas that experienced larger increas in the number and volume of originated loans (Figure 1).2 We find evidence that this relationship is linked to a decrea in lending
1 See, for example, FitchRatings (2007).
2 Indeed, some have compared the current situation to major financial cris in developed countries and emerging market economies (Reinhart and Rogoff, 2008).
standards, as measured by a decline in loan denial rates and a significant increa in loan-to-income ratios, not explained by an improvement in the underlying economic fundamentals. In particular, consistent with recent theories,3 the size of the boom mattered. Denial rates declined more and loan-to-income ratios ro more in areas that experienced larger increas in the number of loan applications.
While limited to a relatively narrow gment of the market, the subprime boom did share other characteristics often associated with aggregate boom-bust credit cycles; the include financial innovation (curitization), changes in market structure, fast rising hou prices, and ample aggregat
e liquidity. We find evidence that all the factors were associated with the decline in lending standards. Denial rates declined more in areas with a larger number of competitors and were further affected by the entry into local markets of large financial institutions. The increasing recour to loan sales and ast curitization appears to have affected lender behavior, with lending standards experiencing greater declines in areas where lenders sold a larger proportion of originated loans. Lending standards declined more in areas with more pronounced housing booms, including when controlling for simultaneity bias. Finally, easy monetary conditions em to have played a role, with the cycle in lending standards mimicking that in the Federal Fund rate. In the subprime mortgage market most of the effects appear to be stronger and more significant than in the prime mortgage market, where loan denial decisions em to be more cloly related to economic fundamentals.
We obtain this evidence in an empirical model where, in addition to taking into account changes in macroeconomic fundamentals, we control for changes in the distribution 3 See the next ction for a brief review of the literature.
bad dayof applicant borrowers and for the potential endogeneity of some of the explanatory variables. Specifically, we develop a two-stage regression framework, explained in detail later on, that exploits i
ndividual loan application data to control for changes in the quality of the pool of loan applicants. We focus on loan applications rather than originations to reduce further the concern for simultaneity bias. For further robustness, we run an instrumental variable specification of our model, where we instrument the subprime applications variable with the number of applications in the prime market.
The contribution of this paper is threefold. First, the paper establishes a link between credit growth (and the growth in the number of originated loans) and lending standards in the subprime mortgage market. This result sheds some light on the origins of the current crisis in the mortgage industry. In particular, it shows that factors such as an incread recour to loan sales and changes in the structure of local credit markets may have amplified the decline in denial rates and the increa in loan-to-income ratios, lending some support to the notion that curitization may have had a dampening effect on bank screening incentives.
Second, the boom-bust cycle of the subprime mortgage market, beyond being of interest in itlf, provides an excellent “lab ca” to study credit booms in general. Indeed, the wealth of information available for this market allows us to control for veral factors, such as changes in the pool of loan applicants, that are difficult to take into account when studying episodes of aggregate credit growth.
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Third, the paper lends empirical support to recent theories linking credit booms and lending standards. In that context, the subprime mortgage market provides an almost ideal testing ground for theories of intermediation bad on asymmetric information (and adver lection in particular). Indeed, subprime borrowers are generally riskier, more
heterogeneous, can post less collateral, and have shorter or wor credit histories (if any) than their prime counterparts.
From a policy standpoint, this paper contributes to the debate on the potential dangers associated with credit booms. There appears to be widespread agreement that periods of rapid credit growth tend to be accompanied by looning lending standards. For instance, in a speech delivered before the Independent Community Bankers of America on March 7, 2001, former Federal Rerve Chairman Alan Greenspan pointed to “an unfortunate tendency” among bankers to lend aggressively at the peak of a cycle and argued that most bad loans were made through this aggressive type of lending.4 In line with this common view, veral studies provide empirical evidence on the cyclicality of lending standards (e below). This paper builds on that literature while focusing on the subprime mortgage market. In addition to documenting the effects of credit booms on lending standards, evidence in this paper suggests that during the episodes banks’ risk-taking may be excessive to th
dice extent that standards decline more than justified by economic fundamentals. Finally, this paper provides hints on the potential effects of monetary policy on banks’ risk-taking, with low interest rates affecting lending standards both directly and through their effect on real estate prices.5 The rest of the paper is organized as follows. Section II reviews the related literature. Section III provides a description of the data and introduces some stylized facts. Section IV describes our empirical methodology. Section V prents the results. Section VI concludes.
4 See also Caruana (2002), Ferguson (2004), and Bernanke (2007).
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5 See Jimenez et al. (2007) for recent evidence on the effects of monetary policy on bank risk-taking.
