I was going to post the abstract from "Credit Booms and Lending Standards: Evidence from the Subprime Mortgage Market, by Giovanni Dell’Ariccia, Deniz Igan, and Luc Laeven, SSRN. But in searching for an open link, I came across a recent summary of the paper from Vox EU. The focus of this research is on identifying the factors that are associated with declining lending standards in the subprime market:
The US subprime mortgage crisis: A credit boom gone bad?, by Giovanni Dell'Ariccia, Deniz Igan, and Luc Laeven, Vox EU: Recent events in the market for mortgage-backed securities have placed the US subprime mortgage industry in the spotlight. Over the last decade, this market has expanded dramatically, evolving from a small niche segment into a major portion of the overall US mortgage market. Can the recent market turmoil – triggered by the sharp increase in delinquency rates – be related to this rapid expansion? In other words, is the recent experience, in part, the result of a credit boom gone bad? While many would say “yes” to these questions, rigorous empirical evidence on the matter has thus far been lacking.
Credit booms There appears to be widespread agreement that periods of rapid credit growth tend to be accompanied by loosening lending standards. For instance, in a speech delivered before the Independent Community Bankers of America on March 7, 2001, former Federal Reserve 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. ...
The mortgage market Reminiscent of this pattern linking credit booms with banking crises, current mortgage delinquencies in the US subprime mortgage market appear indeed to be related to past credit growth (Figure 1). In a new working paper, we analyse data from over 50 million individual loan applications and find that delinquency rates rose more sharply in areas that experienced larger increases in the number and volume of originated loans (Dell’ Ariccia, Igan, and Laeven 2008). This relationship is linked to a decrease in lending standards, as measured by a significant increase in loan-to-income ratios and a decline in denial rates, not explained by improvement in the underlying economic fundamentals.
In turn, the deterioration in lending standards can be linked to five main factors.
- Standards tended to decline more where the credit boom was larger. This is consistent with cross-country evidence on aggregate credit booms.
- Lower standards were associated with a fast rate of house price appreciation, consistent with the notion that lenders were to some extent gambling on a continuing housing boom, relying on the fact that borrowers in default could always liquidate the collateral and repay the loan.
- Changes in market structure mattered: lending standards declined more in regions where large (and aggressive) previously absent institutions entered the market.
- The increasing recourse by banks to loan sales and asset securitisation appears to have affected lender behaviour, with lending standards experiencing greater declines in areas where lenders sold a larger proportion of originated loans.
- Easy monetary conditions seem to have played a role, with the cycle in lending standards mimicking that of the Federal Fund rate. In the subprime mortgage market most of these effects appear to be stronger and more significant than in the prime mortgage market, where loan denial decisions seem to be more closely related to economic fundamentals.
These findings are consistent with the notion that rapid credit growth episodes, due to the cyclicality of lending standards, might create vulnerabilities in the financial system. The subprime experience demonstrates that even highly-developed financial markets are not immune to problems associated with credit booms.
What can be done to curb bad credit booms? Historically, the effectiveness of macroeconomic polices in reducing credit growth has varied (see, for example, Enoch and Ötker-Robe, 2007). While monetary tightening can reduce both the demand and supply of bank loans, its effectiveness is often limited by capital account openness. This is especially the case in small open economies and in countries with more advanced financial sectors, where banks have easy access to foreign credit, including from parent institutions. Monetary tightening may also lead to significant substitution between domestic and foreign-denominated credit, especially in countries with (perceived) rigid exchange rate regimes. Fiscal tightening may also help reduce the expansionary pressures associated with credit booms, though this is often not politically feasible.
While prudential and supervision policies alone may prove not very effective in curbing credit growth, they may be very effective in reducing the risks associated with a boom. Such policies include prudential measures to ensure that banks and supervisors are equipped to deal with enhanced credit risk (such as higher capital and provisioning requirements, more intensive surveillance of potential problem banks, and appropriate disclosure requirements of banks’ risk management policies). Prudential measures may also target specific sources of risks (such as limits on sectoral loan concentration, tighter eligibility and collateral requirements for certain categories of loans, limits on foreign exchange exposure, and maturity mismatch regulations). Other measures may aim at reducing existing distortions and limiting the incentives for excessive borrowing and lending (such as the elimination of implicit guarantees or fiscal incentives for particular types of loans, and public risk awareness campaigns).
In response to aggressive lending practices by mortgage lenders, several states in the US have enacted anti-predatory lending laws. By the end of 2004, at least 23 states had enacted predatory lending laws that regulated the provision of high-risk mortgages. However, research shows that these laws have not been effective in limiting the growth of such mortgages, at least in the US (see, for example, Ho and Pennington-Cross, 2007). At the end of 2006, US federal banking agencies issued two guidelines out of concern that financial institutions had become overexposed to the real estate sector while lending standards and risk management practices had been deteriorating, but these guidelines were too little, too late.
International concerns Other countries thus far seem to have avoided a crisis in their nonprime mortgage markets. The UK, for example, where nonprime mortgages also constitute an increasingly large share of the overall mortgage market, has thus far avoided a surge in delinquencies of such mortgages (though in September 2007, the US subprime crisis indirectly did lead to liquidity problems and eventually a bank run on deposits at Northern Rock, the UK’s fifth largest mortgage lender at the time). Regulatory action on the part of the UK Financial Services Authority, resulting in the 2004 Regulation on Mortgages, which made mortgage lending more prescriptive and transparent in the UK, may have played a role. Of course, only time will tell how successful these actions have been. We would not be surprised to learn that lending standards have also deteriorated in mortgage markets outside the US.
Barajas, Adolfo, Giovanni Dell’Ariccia, and Andrei Levchenko, 2007, “Credit Booms: The Good, the Bad, and the Ugly”, unpublished manuscript, International Monetary Fund.
Dell’Ariccia, Giovanni, Deniz Igan, and Luc Laeven, 2008, “Credit Booms and Lending Standards: Evidence from the Subprime Mortgage Market”, CEPR Discussion Paper No. 6683, London, UK: CEPR.
Enoch, Charles and Inci Ötker-Robe (Editors), 2007, Rapid Credit Growth in Central and Eastern Europe: Endless Boom or Early Warning?, International Monetary Fund and Palgrave MacMillan, New York.
Ho, Giang and Anthony Pennington-Cross, 2007, “The Varying Effects of Predatory Lending Laws on High-Cost Mortgage Applications”, Federal Reserve Bank of St. Louis Review 89(1), pp. 39-59.
Disclaimer: While the authors of this blog are staff members of the International Monetary Fund, the views expressed are entirely the authors’ own. They do not necessarily represent either IMF views or policy, and should not be reported as such.