Taking credit

Kevin Lewis

June 28, 2017

The Hazards of Expert Control: Chief Risk Officers and Risky Derivatives
Kim Pernell, Jiwook Jung & Frank Dobbin
American Sociological Review, June 2017, Pages 511-541


At the turn of the century, regulators introduced policies to control bank risk-taking. Many banks appointed chief risk officers (CROs), yet bank holdings of new, complex, and untested financial derivatives subsequently soared. Why did banks expand use of new derivatives? We suggest that CROs encouraged the rise of new derivatives in two ways. First, we build on institutional arguments about the expert construction of compliance, suggesting that risk experts arrived with an agenda of maximizing risk-adjusted returns, which led them to favor the derivatives. Second, we build on moral licensing arguments to suggest that bank appointment of CROs induced “organizational licensing,” leading trading-desk managers to reduce policing of their own risky behavior. We further argue that CEOs and fund managers bolstered or restrained derivatives use depending on their financial interests. We predict that CEOs favored new derivatives when their compensation rewarded risk-taking, but that both CEOs and fund managers opposed new derivatives when they held large illiquid stakes in banks. We test these predictions using data on derivatives holdings of 157 large banks between 1995 and 2010.

Consumer Ruthlessness and Mortgage Default during the 2007 to 2009 Housing Bust
Neil Bhutta, Jane Dokko & Hui Shan
Journal of Finance, forthcoming


From 2007 to 2009 U.S. house prices plunged and mortgage defaults surged. While ostensibly consistent with widespread “ruthless default,” analysis of detailed mortgage and house price data indicates that borrowers do not walk away until they are deeply underwater – far deeper than traditional models predict. The evidence suggests that lender recourse is not the major driver of this result. We argue that emotional and behavioral factors play an important role in decisions to continue paying. Borrower reluctance to walk away implies that the moral hazard cost of default as a form of social insurance may be lower than suspected.

Gender Equality in Mortgage Lending
Lu Fang & Henry Munneke
Real Estate Economics, forthcoming


Using a sample of 30-year fixed-rate subprime mortgage loans, this paper empirically examines whether gender inequality exists in the mortgage market, specifically, whether a borrower's gender affects the loan contract rate charged, beyond the impact of the borrower's probability of default and prepayment. The results, based on a competing-risks loan hazard model, reveal that borrowers of different gender have different loan termination patterns. After controlling for the probability of a borrower defaulting or prepaying, female borrowers pay higher contract rates in the subprime mortgage market over the study period.

Does Competition Reduce Racial Discrimination in Lending?
Greg Buchak & Adam Tejs Jørring
University of Chicago Working Paper, April 2017


This paper examines whether increases in bank competition reduce discriminatory practices in mortgage lending. Lenders are significantly less likely to approve black applicants' loan applications despite facing similar credit risk. However, following the relaxation of interstate bank branching laws in the 1990s, increases in local lending competition reduced the approval differential between potential white and black borrowers by roughly one quarter. The reduction was driven both by incumbent lenders altering lending policies to avoid losing market share and by the entry of new banks. The results suggest strong complementaries between direct regulation and the competition mechanism. In particular, direct regulation is effective against large lenders where statistical proof problems are less severe, while competition provides incentives to smaller, harder to regulate lenders.

Borrowers in Search of Feedback: Evidence from Consumer Credit Markets
Inessa Liskovich & Maya Shaton
Federal Reserve Working Paper, May 2017


We study recent technological innovation in credit markets and document their role in providing information to households. We show that households value the ability to learn detailed information about their cost of credit. This function is most valued by less creditworthy households with less experience in credit markets. To measure the demand for information provision we exploit a quasi-natural experiment in an online consumer credit market. A large lending platform unexpectedly switched from pricing loans through an auction mechanism to centralized pricing determined by broad credit grade. This change resulted in an instant decrease in the amount of tailored feedback available to market participants. We find that less experienced households immediately and disproportionately exit the market and the response is concentrated among higher risk households. We rule out alternative explanations such as changes in access to credit, borrower risk profiles, and interest rate levels. Our findings point to a potentially important role for financial innovation: enabling less experienced households to more easily learn about their credit market options.

Time Preferences and Mortgage Choice
Stephen Atlas, Eric Johnson & John Payne
Journal of Marketing Research, June 2017, Pages 415-429


Mortgage decisions have important consequences for consumers, lenders, and the state of the economy more generally. Mortgage decisions are also prototypical of consumer financial choices that involve a stream of expenditures and consumption occurring across time. The authors use heterogeneity in time preferences for both immediate (present bias) and long-term outcomes to explain a sequence of mortgage decisions, including mortgage choice and the decision to abandon a mortgage. The authors employ an analytic model and a survey of mortgaged households augmented by zip code–level house price and foreclosure data. The model suggests and data confirm that consumers with greater present bias and long-term discounting tend to choose mortgages that minimize up-front costs. However, greater present bias decreases homeowners’ willingness to abandon a mortgage, locking them into the contract. Long-term patience increases mortgage abandonment. This reversal across mortgage decisions is difficult for alternative accounts to explain. These results suggest that a two-parameter model of time preferences is helpful for understanding how homeowners make mortgage decisions.

Lender Steering in Residential Mortgage Markets
Sumit Agarwal, Brent Ambrose & Vincent Yao
Real Estate Economics, forthcoming


In this paper we examine the incentives for lenders to steer borrowers into piggyback loan structures to circumvent regulations requiring primary mortgage insurance (PMI) for loans with loan-to-value ratios (LTV) above 80%. Our empirical analysis focuses on propensity score matched portfolios of piggyback and single-lien loans having the same combined LTV based on a full set of observed risk characteristics. Our results confirm that mortgages originated with the piggyback structure have much lower ex post default rates and faster prepayment speeds than corresponding PMI loans. We also find a significant causal effect of interstate banking deregulation on the growth of piggybacks in these years, confirming that the ex post performance gap is primarily driven by lender steering on the supply side and not by borrower self-selection. We then perform a number of tests to explore different origination and execution channels of mortgage steering.

Targeted Debt Relief and the Origins of Financial Distress: Experimental Evidence from Distressed Credit Card Borrowers
Will Dobbie & Jae Song
NBER Working Paper, June 2017


We study the drivers of financial distress using a large-scale field experiment that offered randomly selected borrowers a combination of (i) immediate payment reductions to target short-run liquidity constraints and (ii) delayed debt write-downs to target long-run debt constraints. We identify the separate effects of the payment reductions and debt write-downs using variation from both the experiment and cross-sectional differences in treatment intensity. We find that the debt write-downs significantly improved both financial and labor market outcomes despite not taking effect for three to five years. In sharp contrast, there were no positive effects of the more immediate payment reductions. These results run counter to the widespread view that financial distress is largely the result of short-run constraints.

Entrepreneurial optimism, credit availability, and cost of financing: Evidence from U.S. small businesses
Na Dai, Vladimir Ivanov & Rebel Cole
Journal of Corporate Finance, June 2017, Pages 289–307


Using a large sample of U.S. small businesses and a new measure of optimism, we examine the role of entrepreneurial optimism in small business lending. We provide evidence that optimistic entrepreneurs are not rationed by lenders. Quite the opposite, our results suggest that they often have better credit accessibility and obtain lower cost of financing. Our results are robust to alternative measures of optimism and controls for private information between lenders and borrowers.

The Consumer Spending Response to Mortgage Resets: Microdata on Monetary Policy
Kanav Bhagat, Diana Farrell & Vijay Narasiman
Harvard Working Paper, April 2017


In this report, we examine how a sample of US homeowners changed their credit card spending in response to a predictable drop in their mortgage payment driven by the Federal Reserve’s low interest rate policy that followed the Great Recession. Using a de-identified sample of Chase customers who had a hybrid adjustable-rate mortgages (ARM) and a Chase credit card, we analyze changes in credit card spending and revolving balance leading up to and after mortgage reset. We organize our results into four findings. First, forty-four percent of the homeowners in our sample experienced a large drop in their hybrid ARM payment at reset, which on average represented over 5 percent of their monthly income. Second, homeowners increased their spending by 9 percent in advance of the anticipated drop in their mortgage payments and by 15 percent after reset, despite a considerable drop in housing wealth. Third, homeowners used credit card borrowing to finance 21 percent of their pre-reset anticipatory spending increase, and post–reset they further increased their revolving balances. Over the full two year period, their total spending increase exceeded their mortgage-related savings by 4 percent. Fourth, Homeowners used the savings from lower hybrid ARM payments to make more purchases across all spending categories, notably home improvements and healthcare. Overall, we find that in a declining interest rate environment, the income channel that transmits interest rate policy to homeowners with ARMs is automatic, the consumer response is considerable, and that there are both anticipatory and contemporaneous increases in consumption. Additional research is needed to understand if the income channel also has the intended and expected contractionary effects on consumer spending as policy rates move higher. Armed with a full understanding, housing policy makers could evaluate the policies that influence which type of mortgage (fixed-rate or variable-rate) borrowers choose and should consider the effects these policies will have on the ability of monetary policy to impact personal consumption through the business cycle.

House Prices, Mortgage Debt, and Labor Mobility
Radhakrishnan Gopalan et al.
Washington University in St. Louis Working Paper, May 2017


Using detailed credit and employment data for the United States, we estimate the effect of mortgage debt on labor mobility. We find a robust negative relation between the loan-to-value ratio (LTV) of the primary residence and labor mobility. Individuals with negative home equity are 3.6 percentage points less likely to move in a year. This effect is stronger for sub-prime and liquidity-constrained borrowers. We also find that diminished labor mobility owing to higher LTVs depresses labor income growth, especially for individuals with less access to liquidity and longer tenure in their current job. Consistent with a housing-lock explanation, we find that individuals with higher LTVs have higher intra-ZIPcode job mobility. Overall we document significant spillover from the housing market to the labor market.

No Shopping in the U.S. Mortgage Market: Direct and Strategic Effects of Providing Information
Alexei Alexandrov & Sergei Koulayev
Consumer Financial Protection Bureau Working Paper, March 2017


We document and analyze price dispersion in the U.S. mortgage market. We find significant price dispersion in posted prices in the retail channel: for example, a consumer with a prime credit score and with a 20% down payment might see a spread in interest rates of 50 basis points, controlling for all relevant consumer/property characteristics, including discount points. We also show, from survey evidence, that close to half of consumers did not shop before taking out a mortgage, and worse, many consumers do not seem to realize that there is price dispersion. Using a proprietary dataset of lenders' ratesheets, we estimate an equilibrium model of costly search where a share of consumers holds incorrect beliefs regarding price dispersion. Whereas high search costs is one reason behind the lack of search, we show that non-price preferences also play an important role in preventing consumers from searching more; and so an effective policy would target both. In one of our counterfactuals, we show that eliminating non-price preferences results in savings of about $9 billion dollars a year.

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