Banking

Fire sale risk and mortgage origination

Figure 1: Relationship between average changes in neighborhood credit volumes between 2007–2010 and 2004–2006 (y-axis) and aggregate Fire Sale Risk (x-axis).

We test additional mechanisms and conduct several robustness tests. First, we fail to reject that lending decisions on applications for existing houses statistically differ from those on construction loan applications. Also, we exploit variation in borrower default risk and find that lenders’ incentives to mitigate fire sales are amplified when riskier borrowers apply for a mortgage. Taken together, both exercises help us to address the possibility that our proxies do not capture the alternative explanation of propping-up local prices at the first sign of trouble (Giannetti and Saidi, 2018).

Then, we focus on mortgage applications in states with recourse clause to mitigate any confounding effects arising from borrower’s strategic default (Demiroglu et al., 2014). In these circumstances, we find that loss severity effects do not differ from baseline results. Furthermore, we provide evidence that these anticipation effects are amplified for lenders with balance sheet pressures, such as binding equity constraints. This is consistent with the theory that investors with a shorter and more uncertain horizon do more likely consider the deleverage option through asset sales (Morris and Shin, 2004; Ramcharan, 2020). Finally, we investigate whether borrower counteract the terms of the mortgage contract: we find that borrowers are unlikely to reject any hypothetical unfavorable terms that lenders initially offer. As a related point, we examine how mortgage rates on accepted loan applications vary with the fire sale risk. To the extent that expected crowded liquidations decrease a foreclosure payoff, it is likely that lenders charge higher interest rates as compensation.

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Policy implications

The anticipation of fire sale risk suggests that banks prevent illiquidity deadlocks by maximizing their expected loan payoff.  Financial institutions rationally shift portfolio allocation over time from the most pronounced fire sale risk areas to the least ones. These endogenous dynamics make local mortgage markets more concentrated and more diverse, reducing fire sales going forward, and improving financial stability. These results have important policy implications. A regulatory intervention should if anything focus on strengthening lenders’ incentives to internalize fire sale risk (e.g., “skin-in-the-game” regulatory interventions),  rather than on committing to solve ex post inefficiencies (e.g. creation of “bad banks”). In fact, beyond direct organizational costs, ex post measures may lead to unintended consequences, such as ex ante moral hazard (e.g., risk-shifting).

References

Anenberg, E. and Kung, E. (2014). Estimates of the size and source of price declines due to nearby foreclosures. American Economic Review, 104(8):2527–51.

Campbell, J. Y., Giglio, S., and Pathak, P. (2011). Forced sales and house prices. American Economic Review, 101(5):2108–31.

Demiroglu, C., Dudley, E., and James, C. M. (2014). State foreclosure laws and the incidence of mortgage default. The Journal of Law and Economics, 57(1):225–280.

Favara, G. and Giannetti, M. (2017). Forced asset sales and the concentration of outstanding debt: evidence from the mortgage market. The Journal of Finance, 72(3):1081–1118.

Giannetti, M. and Saidi, F. (2018). Shock propagation and banking structure. The Review of Financial Studies, 32(7):2499–2540.

Gupta, A. (2016). Foreclosure contagion and the neighborhood spillover effects of mortgage defaults. The Journal of Finance.

Mayer, C. J. (1995). A model of negotiated sales applied to real estate auctions. Journal of urban Economics, 38(1):1–22.

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Morris, S. and Shin, H. S. (2004). Liquidity black holes. Review of Finance, 8(1):1–18.

Mian, A., Sufi, A., and Trebbi, F. (2015). Foreclosures, house prices, and the real economy. The Journal of Finance, 70(6):2587–2634.

Oehmke, M. (2014). Liquidating illiquid collateral. Journal of Economic Theory, 149:183– 210.

Ramcharan, R. (2020). Banks’ balance sheets and liquidation values: Evidence from real estate collateral. The Review of Financial Studies, 33(2):504–535.

Shleifer, A. and Vishny, R. W. (1992). Liquidation values and debt capacity: A market equilibrium approach. The Journal of Finance, 47(4):1343–1366.

Wagner, W. (2011). Systemic liquidation risk and the diversity–diversification trade-off. The Journal of Finance, 66(4):1141–1175.

Williamson, O. E. (1988). Corporate finance and corporate governance. The journal of finance, 43(3):567–591.

Source : blogs.worldbank.org

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