Bank Diversification Likely Led to Housing Bubble

In a set of academic papers, Elena Loutskina has been evaluating the role mortgage securitization played in the 2007 crisis and unearthed one of the possible causes for the housing bubble.

In her landmark paper “Informed and Uninformed Investment in Housing: The Downside of Diversification,” written with Professor Philip E. Strahan of Boston College, she demonstrates that one likely contributor of the housing bubble may have been financial integration — the linking of financial markets over regional or even global economies.

“Financial integration is rarely fingered as a bad guy. The ability to invest in a wide set of financial markets makes investors and banks happy. It broadens the set of investment opportunities and allows better businesses to obtain funding. But in 2006, the mortgage capital was chasing deals across the U.S. in a hurry. We had too much of a good thing,” says Loutskina.

Using her expertise in securitization — the practice of pooling debt such as residential and commercial mortgages and selling their cash flows to investors as securities — she noted in her paper how “banking deregulation and loan securitization led to a dramatic increase in geographic diversification as banks expanded their operations across markets.”

The push for diversification came about through banks, naturally, chasing profits. “Under the old banking system, those mortgages sat on your balance sheet,” she says. “You have capital requirements. You have to have money to fund the mortgages for the next 30 years. You also care about the quality of those loans. But now you originate the mortgage and turn around and sell it to Fannie Mae or Freddie Mac and retain the origination fee.”

As the securitization markets gained steam, so did the banks’ pursuit of new, fee-based sources of profits. “In response to this business model, what is your first move as a banker? You get as many mortgages as you can. You aggressively expand to new markets and new borrowers,” she says.

In her paper, Loutskina compares two lending methods: traditional and diversified. In the traditional lending model, banks tend to operate in one or a few local markets and hire loan officers who collect “private information” about the borrowers during the origination process.

“Private information is something you can’t measure in numbers. For example, if you have had an account at a bank for a long time, a loan officer can judge you as a devoted, responsible customer,” she says. This private information is more personal and contributes to better lending decisions.

Under the diversified lending model, the loan approval decisions are formed very differently since banks grew by the use of online lending and local brokers. Building branches was expensive and, since it required regulatory approval, time consuming. “Can banks trust the information self-reported by the borrowers online? Can they fully trust mortgage brokers who get paid only if the loan is originated and carry no financial responsibility if this loan subsequently defaults?” she says.

As the banks expanded their lending across the continent, they came to primarily rely on the value of the property, with borrower credit score and mostly self-reported borrower income coming in second place. Banks actively participating in mortgage securitization had no desire to spend money on local loan officers who could collect private information. “They automated the process to oblivion,” Loutskina notes.

The automation and limited data used in the origination decision led to what Loutskina calls uninformed lending. “Think about a couple who want to buy a house in an area where everyone knows a big employer is going to go out of business and send real estate prices down. Someone who originates a mortgage from California or Massachusetts doesn’t have a clue.”

From 1992 to 2006, the market share of local mortgage lenders (those operating in one locality like Boston) dropped from about 18 percent to 4 percent. The new, geographically diversified business model dominated the market pre-crisis.

“Now stop for a second and think what a combination of abundant cheap money with no barriers to travel and technology-based lending did to the mortgage market,” Loutskina says. “Areas with higher housing price appreciation saw more willing investors and thus more happy borrowers, which resulted in even higher housing prices. Lenders were just following the crowd, which fed the bubble further — similar to the stock market bubble of 2000.”

In the paper, Loutskina and her co-author show that areas dominated by geographically diversified banks — like Phoenix or Las Vegas, where 90 percent of the banks were highly diversified and had no appetite or ability to digest private information — had a much higher housing price appreciation over the decade prior to the 2007 crash.

“The results imply that geographic diversification led to a decline in screening by lenders, which likely played a role in the 2007–08 crisis — which is a complicated way to say that lenders got hooked on simply relying on housing prices and refused to do proper screening of loan applicants,” she says.

The financial integration combined with abundant cheap money contributes to the bubble formation. Such bubbles grow until the underpinning lack of realistic value forces them to pop. Everybody tries to jump off the bandwagon at the same time, leading to a broad market collapse.

“Technology in the financial sector is a great thing that pushes the efficiency of the financial sector and the frontiers of financial services forward,” she says. “But sometimes technology is so seductive that it incites people to act irrationally. I hope that the market can correct itself. We have started to see a revival of the local lending business model in last few years.”

Elena Loutskina co-authored “Informed and Uninformed Investment in Housing: The Downside of Diversification,” published in The Review of Financial Studies, with Philip E. Strahan of Boston College’s Carroll School of Management.