Do Financial Counseling Mandates Improve Mortgage Choice and Performance? Evidence from a Legislative Experiment

Abstract:     
We explore the effects of mandatory third-party review of mortgage contracts on the terms, availability, and performance of mortgage credit. Our study is based on a legislative experiment in which the State of Illinois required ‘high-risk’ mortgage applicants acquiring or refinancing properties in 10 specific zip codes to submit loan offers from state-licensed lenders to review by HUD-certified financial counselors. We document that the legislation led to declines in both the supply of and demand for credit, with state licensed lenders and lower-quality borrowers disproportionately exiting the affected area. Controlling for the salient characteristics of the remaining borrowers and lenders, we find that the legislation succeeded in reducing ex post default rates among counseled borrowers by 3 to 4 percentage points (about 30% decline). We attribute this result to actions of lenders responding to the presence of external review and, to a lesser extent, to counseled borrowers renegotiating their loan terms. We also find that the legislation nudged some borrowers to choose less risky loan products in order to avoid counseling.

Keywords: Financial education,Financial literacy,Subprime crisis,Household finance,agency,natural experiment,lending,liquidity,market,mortgages,interest only,fixed rate,adjustable rate,fraud,default,strategic default,legislation,regulation,crisis,bailout,lender,lending,monitoring,screening,delinquincy,agent

JEL Classifications: D14, D18, L85, R21

Working Paper Series