When financial markets are illiquid, investors have incentives to market assets urgently, while potential customers are restricted themselves. Consequently, asset liquidations trade at dislocated-or “fire purchase”-prices (Williamson, 1988 Shleifer and Vishny, 1992 Mayer, 1995). The housing industry throughout the global financial trouble was this type of market. In those days, each additional foreclosed house decreased the cost where other houses within the same neighborhood might be offered (Campbell et al., 2011 Anenberg and Kung, 2014). Within this paper, we empirically investigate whether lenders incorporate the chance of the next dislocated property foreclosure within their decisions to allow financing or otherwise. That’s, do creditors underinvest in collateral assets that at interim might be liquidated at fire purchase prices?
Using comprehensive micro-level data, inside a recent working paper we document that the expected topsy-turvy property foreclosure reduces lenders’ incentives to supply mortgage credit to start with. The anticipation of fireside purchase risk results in socially inefficient credit constraints. Yet, it cuts down on market contact with fire sales moving forward.
Empirical Strategy
This paper adopts the U.S. mortgage market like a research laboratory. We borrow from prior theoretical work two fire purchase risk channels. First, lenders having a large fraction of local share of the market face relatively low fire purchase losses upon customer default simply because they have incentives to mitigate property foreclosure spillovers (Favara and Giannetti, 2017). Consequently, they are able to efficiently provide more liquidity ex ante. By comparison, in spread markets, atomistic lenders rationally anticipate others to become quick to liquidate, giving rise to “rushes towards the exit” (Ohemke, 2014). Second, fire sales are more inclined (and pricey) when in your area active lenders enter into bankruptcy simultaneously. A probable driver of correlated bankruptcy is typical exposures in asset portfolios. Hence, collateral fire purchase risk is greater and credit supply is anticipated to become reduced local markets offered by lenders concentrating on the same portfolios (Wagner, 2011).
We exploit exogenous variation in legal frictions which makes markets less vulnerable to foreclosures to begin with. Perhaps, the fireplace purchase risk ought to be less strong in states where property foreclosure laws and regulations result in the collateral repossession process more pricey and extended to accomplish. Utilizing a comprehensive customer application-level dataset, our empirical strategy involves studying loan provider decision to simply accept mortgage applications controlling for customer, neighborhood, and loan provider characteristics. We select the global financial trouble of 2007-2010 as sample period for the baseline analysis. Because foreclosures were salient and comparatively likely (Gupta, 2016 Mian et al., 2015), we predict a higher signal-to-noise ratio within this period. Furthermore, private securitization was largely impaired, which facilitates identification too.
Results
Our results claim that loan provider tendency to approve mortgage applications increases in her own incentives to renegotiate defaulting mortgages, when outstanding local debts are more concentrated so when lenders locally hold more orthogonal portfolios. Importantly, we discover that all fire purchase risk channels affect loan acceptance decisions to some less extent in states with greater property foreclosure frictions. Figure 1 visually confirms the record outcomes of the paper. The chart around the left implies that more concentrated neighborhoods (x-axis, HHI) exhibit a smaller sized credit decline (y-axis, ?Credit) within the property foreclosure crisis (2007-2010) in accordance with the prior period (2004-2006). Equivalently, the chart around the right implies that local credit volumes (y-axis, ?Credit) decrease less in the quality of portfolio significant difference of local active lenders. Importantly, both relationships are less strong in states in which the property foreclosure process is pricey and requires a lengthy time (orange dots-lines), compared to individuals with low legal frictions to foreclose (red dots-lines).
Figure 1: Relationship between average alterations in neighborhood credit volumes between 2007-2010 and 2004-2006 (y-axis) and aggregate Fire Purchase Risk (x-axis).
Figure 1: Relationship between average alterations in neighborhood credit volumes between 2007-2010 and 2004-2006 (y-axis) and aggregate Fire Purchase Risk (x-axis).
We test additional mechanisms and conduct several sturdiness tests. First, we neglect to reject that lending decisions on applications for existing houses statistically vary from individuals on construction loan requests. Also, we exploit variation in customer default risk and discover that lenders’ incentives to mitigate fire sales are amplified when riskier borrowers obtain a mortgage. Taken together, both exercises allow us to to deal with the chance that our proxies don’t capture the choice explanation of propping-up local prices in the first hint of problems (Giannetti and Saidi, 2018).
Then, we concentrate on mortgage applications in states with option clause to mitigate any confounding effects as a result of borrower’s proper default (Demiroglu et al., 2014). During these conditions, we discover that loss severity effects don’t vary from baseline results. In addition, we prove these anticipation effects are amplified for lenders with balance sheet pressures, for example binding equity constraints. This really is in conjuction with the theory that investors having a shorter and much more uncertain horizon do much more likely think about the deleverage option through asset sales (Morris and Shin, 2004 Ramcharan, 2020). Finally, we investigate whether customer combat the the mortgage contract: we discover that borrowers are unlikely to reject any hypothetical unfavorable terms that lenders initially offer. Like a related point, we examine how home loan rates on recognized loan requests vary using the fire purchase risk. Towards the extent that expected crowded liquidations decrease a property foreclosure payoff, chances are that lenders charge greater rates of interest as compensation.
Policy implications
The anticipation of fireside purchase risk shows that banks prevent illiquidity deadlocks by maximizing their expected loan payoff. Banking institutions rationally shift portfolio allocation with time in the most pronounced fire purchase risk areas towards the least ones. These endogenous dynamics make local mortgage markets more concentrated and much more diverse, reducing fire sales moving forward, and improving financial stability. These results have important policy implications. A regulatory intervention should contrary concentrate on strengthening lenders’ incentives to internalize fire purchase risk (e.g., “skin-in-the-game” regulatory interventions), instead of on investing in solve ex publish inefficiencies (e.g. development of “bad banks”). Actually, beyond direct business costs, ex publish measures can lead to unintended effects, for example ex ante moral hazard (e.g., risk-shifting).
References
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