Black Box, Greenleaf: Lender Behavior Under Uncertain Collateral Enforcement

Abstract

This paper uses a shock to downside risk in contract enforcement to study lender behavior when collateral enforcement becomes uncertain. I exploit quasi-experimental variation from Maine's 2014 Greenleaf judgment that increased enforcement costs on existing creditors but mechanically left new lenders unaffected. I estimate that the most exposed banks restricted lending by 21%, almost exclusively for portfolio loans. I provide evidence that this contraction in credit was not driven by balance sheet losses or capital flight on the part of investors. Exploring the mechanism, I find that banks likely tightened lending standards following the judgment. Consequently, exposed banks issued safer loans and denied high debt-to-income loan applications above the conforming loan limit. Furthermore, the salience of the shock increased in proximity to the judgment, size of the bank, and bank portfolio concentration. Lastly, following the judgment, I identify spillovers to other bank operations and the local economy. Small business lending increased in bank branch localities, house prices fell in the most exposed zip codes, and exposed counties experienced an increase in unemployment.

Keywords: Banking, Financial Intermediation, Real Estate Finance, Uncertainty, Lender Beliefs, Collateralized Lending, Collateral Enforcement, Credit Supply, Foreclosure, Portfolio Lending

JEL Classification: G20, G21, H81, R30