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Mortgage companies and regulatory arbitrage

Listed author(s):
  • Yuliya Demyanyk
  • Elena Loutskina

Mortgage companies (MCs) originated about 60% of all mortgages before the 2007 crisis and continue to hold a 30% market share postcrisis. While financial regulations are strictly enforced for depository institutions (banks), they are weakly enforced for MCs even if they are subsidiaries of a bank holding company (BHC). This study documents that the resulting regulatory arbitrage creates incentives for BHCs to engage in risk shifting through their MC affiliates. We show that MCs are established to circumvent the capital requirements and to shield the parent BHCs from loan-related losses. BHCs run the risky mortgage business through their MC affiliates. As compared to bank affiliates of BHCs, the MC affiliates lent more to individuals with lower credit scores, lower incomes, and higher loan-to-income ratios. MC borrowers experienced higher rates of foreclosure and delinquency during the crisis. Our results imply that the regulation in place had the capacity to prevent the deterioration of lending standards widely blamed for the crisis. The inconsistent enforcement of regulation, though, eroded its effectiveness. Higher involvement of mortgage companies in subprime lending and securitization activity do not explain our results.

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Paper provided by Federal Reserve Bank of Cleveland in its series Working Paper with number 1220R.

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Date of creation: 2012
Date of revision: 01 Apr 2014
Handle: RePEc:fip:fedcwp:1220
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