What Fuels the Boom Drives the Bust: Regulation and the Mortgage Crisis

Abstract

This article examines the impact of regulation on lending standards during the mortgage boom. We exploit the overall regulatory wedge between banks and independent mortgage companies (IMCs) and a variation in this regulatory wedge across states induced by a cross-sectional variation in state laws under which IMCs operated. The weakly regulated IMCs contributed disproportionately to the explosion in risky lending and to the subsequent rise in delinquency. Consistent with regulations imposing binding constraints on lending standards, we show that these patterns were significantly less pronounced in states with tighter regulations using a sample of county pairs straddling state borders. These and other findings in the paper highlight how inconsistent regulation of mortgage lenders has resulted in risky lending being increasingly channeled through the least regulated lenders during the boom, as market discipline deteriorated.

Keywords: Regulation, Independent lenders, lending standards, county data, credit supply, matching estimator

JEL Classification: G01, G11, G12, G13, G14, G21