A Bright, Predictable Line Between Underwriting, Credit Availability

LOS ANGELES–In the aftermath of the financial crisis and facing new regulatory requirements, mortgage lenders tightened underwriting standards. The results were seismic.

Loan quality improved dramatically. But for many would-be home buyers, credit dried up, as tighter underwriting requirements shut out large numbers of borrowers, many of whom arguably were creditworthy.

In examining data from 1990 to 2013, Benjamin Kay, research economist with the U.S. Treasury Office of Financial Research, said the results became measureable–and predictable.

“The financial crisis renewed interest in the real consequences of bank loan underwriting standards,” Kay said here at the Mortgage Bankers Association’s Risk Management, Quality Assurance & Fraud Prevention Conference. “In particular, residential mortgage lending standards have been implicated as a key contributing factor for the severity and length of the financial crisis.”

Measuring industry-wide credit availability is important for regulators, policy-makers and lenders alike, Kay said. He presented findings of a recent paper, The Real Consequences of Bank Mortgage Lending Standards (co-authored with Cindy Vojtech and John Driscoll), a comprehensive look at mortgage data from disparate indexes capturing different aspects of the mortgage market.

“There is tremendous transparency in what is going on in the residential mortgage lending industry that isn’t readily available in other industries,” Kay said, citing research from the Home Mortgage Disclosure Act, CoreLogic, the MBA Mortgage Credit Availability Index, the Bureau of Labor Statistics and other companies and agencies. “Combing these data create lending standards at the national, state and metro level.”

Combining these with responses from the Federal Reserve Senior Loan Officer Opinion Survey on Bank Lending Practices to characterize banks’ changes in residential mortgage lending standards, the paper found, a significant variation of denial rates across banks, even during the most recent housing boom in the mid-2000s. “This gave us confidence that there isn’t a national story, but that we had to get into the weeds of what each bank was doing,” Kay said.

The results showed that when banks decide to tighten standards, denial rates typically jump nationally by one percentage point; implying a reduction in aggregate mortgage credit of nearly $700 million per quarter. Denial rate changes are larger for banks that hold most of their mortgages on portfolio (rather than securitizing them). Tighter standards are associated with nearly 16 percent fewer high interest rate loans–a proxy for riskier loans.

“Applications rise at banks that report strengthening demand for mortgage loans,” Kay said, adding that metropolitan statistical areas that have more exposure to banks that have tightened standards have much lower delinquency rates two years following the tightening suggesting that standards are an important determinant of the credit quality of bank loan portfolios. “We estimate that mortgage credit falls by about 5 percent when standards tighten and rises by about 4 percent when demand for such credit strengthens.”

Not surprisingly, the paper found that metropolitan areas that had more exposure to banks that tightened standards had much lower delinquency rates two years following the tightening. “This suggests that when banks tighten standards they are successful in not extending credit to borrowers who will have trouble repaying their debts,” Kay said. “It also suggests that SLOOS credit standards are a leading indicator of financial industry vulnerability to shocks.”

A further consequence of the impact of bank lending standards on local housing markets shows up in home prices, the paper said, noting that in MSAs with more exposure to SLOOS banks that have tightened standards, house prices decline–by as much as 2 percent–as one would expect from the decline in approved mortgages in such areas.

“Banks, when they want to take on more risk, take on borrowers with higher risks and when they want to tighten standards, make loans to less risky borrowers,” Kay said.

The paper is available at https://financialresearch.gov/working-papers/files/OFRwp-2016-05_Real-Consequences-of-Bank-Mortgage-Lending-Standards.pdf.