Relaxed Lending Standards and the 2007 Mortgage Crisis: Gap between Household Desired and Actual Stock of Debt

Abstract:     
This paper adds to the existing literature on the 2007 subprime mortgage crisis and the relaxed lending standards that appeared to occur before this crisis. Using the Survey of Consumer Finances (SCF) data, this paper examines the household debt as evidence of changing characteristics of lending under easy credit conditions. This paper compares the levels of household debt from 1998, when subprime lending was popular but before relaxed lending standards, to 2007, after which relaxed lending standards had been in effect for some time. In particular, this paper studies the gap between households’ desired and outstanding debt levels and how this gap has changed from 1998 to 2007. This paper is the first, among the existing literature on the 2007 subprime mortgage crisis, to look into this gap. The hypothesis is that the gap will decline given that credit constrained households will have more access to credit and will borrow a greater portion of their desired debt levels under relaxed lending standards. The gap is calculated in three steps. 1) Estimate desired debt levels for unconstrained households through three-equation-generalized-Tobit, by using the households’ outstanding debt levels which are observed in the data; 2) Predict desired debt levels for constrained households by using the estimated coefficient values from step 1; 3)Measure the gap between the predicted debt levels and the observed debt levels. For study purposes, permanent income is constructed by earnings equation estimation and net worth is instrumented. Different than the previous literature on household debt, the sample includes high income households and the oversampling of high income households has been adjusted by using the sampling weights that are provided by the SCF data. Additionally, the standard errors are bootstrapped. The findings show a declining gap for households with income levels between $30,000 and $60,000 and for households with income levels above $345,000. The findings also display a declining gap for households with household heads less than or equal to 34 years old and household heads between 54 and 65 years old. A decline in the gap levels indicates that constrained households borrowed more of their desired debt levels. In the future, if the gap declines, the regulators (including the Financial Stability Oversight Council and the Consumer Financial Protection Bureau) can take this as a warning mechanism as to whether constrained households had greater loan opportunities at the expense of loan quality and can take preventive measures before stability of the U.S. financial system is threatened and households are negatively affected by bad lending practices.

Number of Pages in PDF File: 46

Keywords: Subprime Mortgage Crisis, Lending Characteristics, Household Debt, Desired Debt, Permanent Income, Survey of Consumer Finances

JEL Classification: D12, D91, G21

working papers series