Don't bank on it
Natasha Sarin & Lawrence Summers
Harvard Working Paper, September 2016
Abstract:
Since the financial crisis, there have been major changes in the regulation of large financial institutions directed at reducing their risk. Measures of regulatory capital have substantially increased; leverage ratios have been reduced; and stress testing has sought to further assure safety by raising levels of capital and reducing risk taking. Standard financial theories would predict that such changes would lead to substantial declines in financial market measures of risk. For major institutions in the United States and around the world and midsized institutions in the United States, we test this proposition using information on stock price volatility, option-based estimates of future volatility, beta, credit default swaps, earnings-price ratios, and preferred stock yields. To our surprise, we find that financial market information provides little support for the view that major institutions are significantly safer than they were before the crisis and some support for the notion that risks have actually increased. This does not make a case against the regulatory approaches that have been pursued, but does caution against complacency. We examine a number of possible explanations for our surprising findings. We conclude that financial markets may have underestimated risk prior to the crisis and that there may have been significant distortions in measures of regulatory capital. While we cannot rule out these explanations, we believe that our findings are most consistent with a dramatic decline in the franchise value of major financial institutions, caused at least in part by new regulations. This decline in franchise value makes financial institutions more vulnerable to adverse shocks. We highlight that the ratio of the market value of common equity to assets on both a risk-adjusted and risk-unadjusted basis has declined significantly for most major institutions. Our findings, if validated by others, may have important implications for regulatory policy.
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Systematic Mistakes in the Mortgage Market and Lack of Financial Sophistication
Sumit Agarwal, Itzhak Ben-David & Vincent Yao
Journal of Financial Economics, forthcoming
Abstract:
Institutions often offer a menu of contracts to consumers in an attempt to create a separating equilibrium that reveals borrower types and provides better pricing. We test the effectiveness of a specific set of contracts in the mortgage market: mortgage points. Points allow borrowers to exchange an upfront amount for a decrease in the mortgage rate. We document that, on average, points takers lose about $700. Also, points takers are less financially savvy (less educated, older), and they make mistakes on other dimensions (e.g., inefficiently refinancing their mortgages). Overall, our results show that borrowers overestimate how long they will stay with the mortgage.
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Cat and Mouse: A Dynamic Analysis of Predatory Payday Lending
Daria Roithmayr, Justin Chin & Bruce Levin
University of Southern California Working Paper, August 2016
Abstract:
Legal actors and the regulators who pursue them often engage in a co-evolutionary game of cat and mouse, as each innovates to out-compete the other. Predatory payday lenders are a prime example of this co-evolutionary arms race. Lenders have discovered increasingly creative ways to escape state regulation, like partnering with Indian tribes to claim immunity from state jurisdiction. In turn, regulators continually adapt their regulation to retarget the latest innovation. A regulator trying to keep pace with legal actors faces a tradeoff: adapting more frequently reduces the prohibited behavior, but increases wasteful innovation for both regulator and lenders, as each innovates in response to the other. In this paper, we draw from dynamic mathematical models of drug resistance to map this process and to advise regulators on how to optimize their regulatory approach. We construct a simple mathematical model using coupled differential equations to describe the arms race of innovation between regulatory strategy and the strategy of the regulated, in the context of payday lending. We conduct numerical approximations, to analyze the evolutionary pathways of regulator and lender strategy over time, and to map the tradeoff between the benefit from reducing predatory lending and the harm from having to return again and again to the drawing board to generate new regulation. We show that, contrary to intuition, a regulator should delay responding to an innovative payday lender strategy: we calculate an optimal response time that balances the need to respond slowly in order to minimize triggering repeated innovation, and the need to respond quickly to minimize the number of predatory payday lenders. We also show that a regulator that is unable to adapt quickly should weaken the strength of its innovation, in order to minimize further innovation by predatory lenders.
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Ditching the Middle Class with Consumer Protection Regulation
Francesco D'Acunto & Alberto Rossi
University of Maryland Working Paper, September 2016
Abstract:
We analyze the effects of a recent piece of consumer protection regulation -- Dodd-Frank -- on mortgage originations. Dodd-Frank aimed at reducing mortgage fees and abuses against vulnerable borrowers, but increased the costs of originating mortgages. We find it triggered a substantial redistribution of credit from middle-class households to wealthy households. Lenders reduced credit to middle-class households by 15%, and increased it to wealthy households by 21%, after controlling for drivers of the demand for housing, local house prices, and foreclosures. Large lenders found it less costly to react to Dodd-Frank. We thus instrument households' exposure to Dodd-Frank with the pre-crisis share of mortgages originated by large lenders in each county. The redistribution of credit from the middle-class to the wealthy was higher in counties more exposed to large lenders, which are similar to other counties. Results hold at the individual-loan level and zip-code level, at the intensive margin (amount lent) and extensive margin (number of loans originated), and for accepted and rejected loans. Changes in the distribution of refinancing loans do not explain the results.
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Consumer Borrowing after Payday Loan Bans
Neil Bhutta, Jacob Goldin & Tatiana Homonoff
Journal of Law and Economics, February 2016, Pages 225-259
Abstract:
High-interest payday loans have proliferated in recent years; so too have efforts to regulate them. Yet how borrowers respond to such regulations remains largely unknown. Drawing on both administrative and survey data, we exploit variation in payday-lending laws to study the effect of payday loan restrictions on consumer borrowing. We find that although such policies are effective at reducing payday lending, consumers respond by shifting to other forms of high-interest credit (for example, pawnshop loans) rather than traditional credit instruments (for example, credit cards). Such shifting is present, but less pronounced, for the lowest-income payday loan users. Our results suggest that policies that target payday lending in isolation may be ineffective at reducing consumers’ reliance on high-interest credit.
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Managerial Myopia and the Mortgage Meltdown
Adam Kolasinski & Nan Yang
Texas A&M University Working Paper, July 2016
Abstract:
Prominent policy makers assert that managerial short-termism was at the root of the subprime mortgage crisis of 2007-2009. Prior scholarly research, however, largely rejects this assertion. Using a more comprehensive measure of CEO incentives for short-termism, we uncover evidence that short-termism indeed played a role in the crisis. We find that shorter vesting schedules for CEO equity holdings are positively related to firm exposure to subprime mortgage assets, as well as a higher probability of financial distress and lower risk-adjusted stock returns during the crisis. Furthermore, shorter vesting schedules are positively associated with fines and settlements for subprime-related fraud.
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How Does Personal Bankruptcy Law Affect Startups?
Geraldo Cerqueiro & María Fabiana Penas
Review of Financial Studies, forthcoming
Abstract:
We exploit state-level changes in the amount of personal wealth individuals can protect under Chapter 7 to analyze the effect of debtor protection on the financing structure and performance of a representative panel of U.S. startups. The effect of increasing debtor protection depends on the entrepreneur's level of wealth. Firms owned by mid-wealth entrepreneurs whose assets become fully protected suffer a reduction in credit availability, employment, operating efficiency, and survival rates. We find no such negative effects for low-wealth and high-wealth owners. Our results are consistent with theories that predict that asset protection in bankruptcy leads to a redistribution of credit.
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Debtor Rights, Credit Supply, and Innovation
Geraldo Cerqueiro et al.
Management Science, forthcoming
Abstract:
Firms’ innovative activities can be sensitive to public policies that affect the availability of capital. In this paper, we investigate the effects of regional and temporal variation in U.S. personal bankruptcy laws on firms’ innovative activities. We find that bankruptcy laws that provide stronger debtor protection decrease the number of patents produced by small firms. Stronger debtor protection also decreases the average quality, and variance in quality, of firms’ patents. We find evidence that the negative effect of stronger debtor protection on experimentation and innovation may be due to the decreased availability of external financing in response to stronger debtor rights, an effect amplified in industries with a high dependence on external financing. Hence, while it is typically assumed that stronger debtor protection encourages innovation by reducing the cost of failure for innovators, we show that it can instead dampen innovative activities by tightening the availability of external financing to innovative firms.
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International Banking and Cross-border Effects of Regulation: Lessons from the United States
Jose Berrospide et al.
NBER Working Paper, September 2016
Abstract:
Domestic prudential regulation can have unintended effects across borders and may be less effective in an environment where banks operate globally. Using U.S. micro-banking data for the first quarter of 2000 through the third quarter of 2013, this study shows that some regulatory changes indeed spill over. First, a foreign country’s tightening of limits on loan-to-value ratios and local currency reserve requirements increase lending growth in the United States through the U.S. branches and subsidiaries of foreign banks. Second, a foreign tightening of capital requirements shifts lending by U.S. global banks away from the country where the tightening occurs to the United States and to other countries. Third, tighter U.S. capital regulation reduces lending by large U.S. global banks to foreign residents.
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Illiquidity and its Discontents: Trading Delays and Foreclosures in the Housing Market
Aaron Hedlund
Journal of Monetary Economics, October 2016, Pages 1–13
Abstract:
The macroeconomic effects of housing illiquidity are analyzed using a novel directed search model of housing with long-term debt and default. Debt overhang emerges when highly leveraged sellers are forced to post high prices that produce long selling delays. These delays increase foreclosures, raise default premia, and curtail credit. Cheaper credit fuels temporarily higher house prices, faster sales, and fewer foreclosures, but the borrowing surge facilitates future debt overhang and default. More stringent foreclosure punishments also expand credit and, therefore, either generate higher foreclosures or more debt overhang. Leverage caps avoid this conundrum but reduce welfare by restricting borrowing.
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Antonio Bernardo, Eric Talley & Ivo Welch
Journal of Law and Economics, February 2016, Pages 75-104
Abstract:
Although common economic wisdom suggests that government bailouts are inefficient because they reduce incentives to avoid failure and induce excessive entry by marginal firms, in practice bailouts are difficult to avoid for systemically significant enterprises. Recent experience suggests that bailouts also induce litigation from shareholders and managers complaining about expropriation and wrongful termination by the government. Our model shows how governments can design tax-financed corporate bailouts to reduce these distortions and points to the causes of inefficiencies in real-world implementations such as the Troubled Asset Relief Program. Bailouts with minimal distortion depend critically on the government’s ability to expropriate shareholders and terminate managers.
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William Bunting
U.S. Department of Justice Working Paper, August 2016
Abstract:
This study provides estimates of the impact of increased access to home mortgage credit on local crime rates, and uses national home mortgage loan origination volume as an instrument for local home mortgage loan origination volume. The focus of the study is San Diego County from 2007-Q1 to 2013-Q1. Our estimates indicate that increased access to home mortgage loans during this time period had a statistically significant negative impact on local crime rates. In particular, our baseline specification suggests that a one standard deviation increase in home mortgage loan originations per person decreases local crime rates by approximately three and one-half percent. This finding is robust to a number of model specifications.
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Does inequality lead to credit growth? Testing the Rajan hypothesis using state-level data
Steven Yamarik, Makram El-Shagi & Guy Yamashiro
Economics Letters, forthcoming
Abstract:
This paper uses state-level data to test the Rajan hypothesis, from his book Fault Lines, that an increase in inequality can lead to a credit boom. Using dynamic heterogeneous panel estimation methods (i.e. MG, PMG, DFE), we find a significant positive long-run relationship between inequality and real estate lending across U.S. states.
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Mortgage Default Risk: New Evidence From Internet Search Queries
Marcelle Chauvet, Stuart Gabriel & Chandler Lutz
Journal of Urban Economics, forthcoming
Abstract:
We use Google search query data to develop a broad-based and real-time index of mortgage default risk. Unlike established indicators, our Mortgage Default Risk Index (MDRI) directly reflects households’ concerns regarding their risk of mortgage default. The MDRI predicts housing returns, mortgage delinquency indicators, and subprime credit default swaps. These results persist both in- and out-of-sample and at multiple data frequencies. Together, research findings suggest internet search queries yield valuable new insights into household mortgage default risk.
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Mortgage companies and regulatory arbitrage
Yuliya Demyanyk & Elena Loutskina
Journal of Financial Economics, forthcoming
Abstract:
Mortgage companies (MCs) do not fall under the strict regulatory regime of depository institutions. We empirically show that this gap resulted in regulatory arbitrage and allowed bank holding companies (BHCs) to circumvent consumer compliance regulations, mitigate capital requirements, and reduce exposure to loan-related losses. Compared to bank subsidiaries, MC subsidiaries of BHCs originated riskier mortgages to borrowers with lower credit scores, lower incomes, higher loan-to-income ratios, and higher default rates. Our results imply that precrisis regulations had the capacity to mitigate the deterioration of lending standards if consistently applied and enforced for all types of intermediaries.
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The effect of state bans of payday lending on consumer credit delinquencies
Chintal Desai & Gregory Elliehausen
Quarterly Review of Economics and Finance, forthcoming
Abstract:
The debt trap hypothesis implicates payday loans as a factor exacerbating consumers’ financial distress. Accordingly, restricting access to payday loans would be expected to reduce delinquencies on mainstream credit products. We test this implication of the hypothesis by analyzing delinquencies on revolving, retail, and installment credit in Georgia, North Carolina, and Oregon. These states reduced availability of payday loans by either banning them outright or capping the fees charged by payday lenders at a low level. We find small, mostly positive, but often insignificant changes in delinquencies after the payday loan bans. In Georgia, however, we find mixed evidence: an increase in revolving credit delinquencies but a decrease in installment credit delinquencies. These findings suggest that payday loans may cause little harm while providing benefits, albeit small ones, to some consumers. With more states and the federal Consumer Financial Protection Bureau considering payday regulations that may limit availability of a product that appears to benefit some consumers, further study and caution are warranted.
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Are Lemons Sold First? Dynamic Signaling in the Mortgage Market
Manuel Adelino, Kristopher Gerardi & Barney Hartman-Glaser
Federal Reserve Working Paper, July 2016
Abstract:
A central result in the theory of adverse selection in asset markets is that informed sellers can signal quality by delaying trade. This paper uses the residential mortgage market as a laboratory to test this mechanism. Using detailed, loan-level data on privately securitized mortgages, we find a strong relation between mortgage performance and time-to-sale. Importantly, this finding is conditional on all observable information about the loans. This effect is strongest in the "Alt-A" segment of the market, where loans are often originated with incomplete documentation. The results provide some of the first evidence of a signaling mechanism through delay of trade.
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How do financial institutions react to a tax increase?
Alexander Schandlbauer
Journal of Financial Intermediation, forthcoming
Abstract:
This paper empirically highlights the role and significance of taxes for the capital structure decisions of banks. Using a difference-in-differences methodology, I show that an increase in the local U.S. state corporate tax rate affects the banks’ financing as well as their operating choices. Better-capitalized banks raise their long-term non-depository debt and thus benefit from an enlarged tax shield. Worse-capitalized banks instead reduce their lending because a higher tax rate increases the tax-adjusted cost of funding, which renders the marginal loan unprofitable.