WHAT FUELS THE BOOM DRIVES THE BUST: Uneven regulation and the US mortgage crisis

Stricter supervision and regulation of independent mortgage lenders could have reduced the severity of the boom-bust cycle in the US housing market, according to research by Jihad Dagher and Ning Fu, published in the June 2017 issue of the Economic Journal.

Their study shows that lending by loosely regulated non-bank companies was associated with higher foreclosure during the housing downturn compared with lending by the more tightly regulated banks. They trace the impact of regulation by taking advantage of the variation in state laws on predatory lending, which predominantly applied to non-bank lenders.

The results suggest that enhanced supervision, which is what ultimately differentiated banks from non-banks, could be a first step in the right direction. But enhanced supervision alone is unlikely to be effective at substantially reducing risky lending without additional mortgage-specific regulations that set higher lending standards and eliminate some of the perverse economic incentives that were behind the boom.


The far-reaching consequences of the US mortgage crisis have sent economists and policy-makers searching for a better understanding of what drove the housing bubble. There is substantial evidence that the unprecedented mortgage boom was fuelled by a deterioration in lending standards, which was at least partly due to a moral hazard problem created by securitising loans – the ''originate to distribute'' model.

Yet despite the idea that enhanced regulation and supervision could have averted bad lending remains a theoretical premise with little empirical work to validate such link. The calls for tighter regulation are often met with criticism cautioning against an inefficient knee-jerk regulatory reaction to the financial crisis.

The new study examines the impact of regulation on lending standards by exploiting the difference in the regulatory structure of mortgage lenders. The authors show that lending by the less regulated mortgage lenders was associated with a sharper rise in foreclosures during the housing downturn.

Mortgage originators face uneven regulation

Prior to the crisis, US mortgage lenders operated under different regulatory structures with differing degrees of oversight, depending on their status. This difference is most pronounced between bank and non-bank mortgage originators.

It is widely recognised that non-bank independent lenders were only mildly regulated and supervised before the crisis, while their bank counterparts were subject to a range of federal laws and examinations. In fact, independent lenders escaped most federal laws and were only lightly regulated at state level.

This stark difference in the extent of regulation has led to calls for establishing a federal regulator to develop uniform national mortgage standards and regulate independent mortgage lenders.

Independent lenders contributed disproportionally to the mortgage boom

Using comprehensive data on home mortgage originations made available by the Home Mortgage Disclosure Act, the researchers distinguish between originations by banks (banks and their affiliates) and non-bank independent lenders.

Examining the unprecedented growth in mortgage origination during the period 2003-05, they find that independent lenders contributed disproportionally to the credit expansion. Notably, from a market share of around 30% in 2003, independents contributed to around 60% of the increase in mortgage originations between 2003 and 2005. This expansion took place across most major US counties.

It is important to note that banks and independents served a similar clientele in that the distribution of income of borrowers from each type of lender is relatively similar.

The early rise in foreclosures and the lender type

The researchers investigate whether foreclosure outcomes, in addition to being determined by county characteristics and the extent of the housing boom, were also dependent on the type of the lender. In other words, they ask whether, everything else equal, lending by independents was associated with worst outcomes.

The results consistently show a strong positive relationship between the presence of independents and the rise in foreclosures. Furthermore, this relationship is economically meaningful in that the rise in foreclosure associated with one standard deviation increase in the market share of independents is around one half of the increase in foreclosure filing rates between 2005 and 2007.

The study also finds that this relationship cannot be explained away by differences in securitisation rates between the two types of lenders. Since the rise in foreclosure pre-dated and fuelled the subsequent collapse in house prices, the contraction in mortgage credit and ultimately the rise in unemployment in 2008, the market share of independents as of 2005 is a strong predictor of these events.

Is it really regulation?

Can the association between lending by independents and the rise in foreclosures really be attributed to their lack of regulation and supervision? The researchers make use of variations in anti-predatory lending regulations across states to address this question. Since federally supervised banks escaped such regulations (as discussed in their paper which reviews the legal literature on this matter) any state regulation that constrains risky lending could have only affected lending by non-banks.

Using an index of anti-predatory lending state laws, the study finds that the impact of independents on foreclosures is significantly more severe in the less regulated states. This difference-in-difference approach, in a sample of neighbouring counties straddling state borders, addresses potential confounding factors, and thus provides strong evidence of causality between regulation and lending standards.

''What Fuels the Boom Drives the Bust: Regulation and the Mortgage Crisis'' by Jihad Dagher and Ning Fu is published in the June 2017 issue of the Economic Journal. Jihad Dagher is at the International Monetary Fund (IMF). Ning Fu is at Instiglio. The views expressed are those of the authors and should not be attributed to the IMF, its Executive Board, or its management.