In this dissertation, I consider various aspects of the U.S. residential mortgage
lending market in 2005. In particular, I examine how existing regulations may have
contributed to the mortgage default crisis that began in early 2007.
The first chapter of the dissertation is concerned with the Community Reinvestment
Act (CRA). The CRA is a federal lending regulation that creates incentives
for depository institutions to lend in low- and moderate-income areas. Only a subset
of market areas is closely monitored by the regulators. I exploit this CRA enforcement
mechanism to identify its effect on the banks’ loan approval decisions. I
employ a novel nonlinear Bayesian Instrumental Variables method to quantify the
above effect while admitting unobserved heterogeneity among mortgage lenders. I
find that, other things equal, loans in closely monitored areas have a 21:7 percent
higher average chance of being approved. This implies that more than 327; 000 extra
loans originated in 2005 in California and suggests that banks’ responses to the
CRA enforcement mechanism sharply contradict the original CRA goals of providing
credit in all eligible neighborhoods. Namely, CRA-induced incentives led
banks to issue substantially more loans to marginal borrowers in monitored areas.
The second chapter of the dissertation explores the degree of strategic interactions
among mortgage lenders and how these interactions differ depending on
the regulatory agency. Conventional economic wisdom suggests that competition
among mortgage lenders will result in overall welfare improvements. Recent theoretical research challenges this wisdom. Using the data concerning home mortgage
loan applications, I test the “race-to-the-bottom” hypothesis that competition
among lenders causes them to relax lending standards. I exploit the recently developed
structural methods of estimating static games with incomplete information to identify how lenders form beliefs about the actions of their competitors. I find
strong evidence supporting the “race-to-the-bottom” story among all types of mortgage
lenders, with the exception of those regulated by the Federal Reserve System.
Thus, my results provide a partial explanation for the subprime mortgage collapse
of the early 2007.