Working Paper

Mortgage companies and regulatory arbitrage

Abstract: 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.

Keywords: Banks and banking; Mortgages; Foreclosure; Regulation;

Bibliographic Information

Provider: Federal Reserve Bank of Cleveland

Part of Series: Working Papers (Old Series)

Publication Date: 2014-04-01

Number: 1220R