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After the 2008 housing foreclosure crisis, people were curious how adverse conditions led to severe credit shortages and what could be learned to avoid similar recovery challenges in the future.

Until now most of the research in this area has focused more on the fundamental macroeconomic channels. However, a recent study by Dean’s Professor of Finance Yuhai Xuan at The UCI Paul Merage School of Business took a more micro-level, behavioral approach to examine the biases of individual loan officers.

Xuan partnered with co-authors, Da (Derek) Huo of the University of Hong Kong, Bo Sun of the University of Virginia, and Mingzhu Tai of the University of Hong Kong to study the question in more depth. Their article, “Lending Next to the Courthouse: Exposure to Adverse Events and Mortgage Lending Decisions”, soon to be published in The Journal of Financial and Quantitative Analysis, explores how adverse market conditions might have influenced loan officers’ risk taking when they decide whether to accept or reject applications.

“We were interested in studying a behavioral channel in the financial market,” says Xuan, “and exploring how individual decision-makers are influenced by adverse market conditions through this behavioral channel. In this study, our concern was in credit markets and mortgage applications.”

Behavioral Factors

In academia people usually think about adverse market events like foreclosures, as seen widely during the 2008 financial crisis, and how that might affect credit supply. But Xuan and his team wanted to explore factors outside the basics of financial fundamentals.

“We wanted to look at those individual decision-makers in the U.S. mortgage market,” says Xuan, “to measure specific changes at the micro level. Our study aimed to examine specific loan applications and link the decisions of loan officers across various locations to when and where the applications were submitted.”

To find that data, Xuan and his team looked at loan applications based on geographic factors. “There is a public disclosure version of this type of data at the annual level, but we also obtained additional data from the Federal Reserve Bank which was more high-frequency data giving us a month-by-month detail of mortgage rejection rates in response to the foreclosure events,” he says.

“This data not only gave us rejection decisions, but also loan performance data; meaning that after the loan is approved we could see how well that loan performed. So, by looking at 1.2 million loan applications, we then inferred the location of these mortgage offices to determine where the loan takes place, and whether the loan was approved or not.”

Proximity Effect

To find their answers, Xuan and his co-authors knew they needed what’s known as a shock. “We needed to see if the decision makers acted differently depending on the location of their branch office and how that might affect their individual risk-taking behaviors,” says Xuan. “Within the same neighborhood or county, for example, we needed differentiation between individuals at various loan offices.”

That differentiation ended up revolving around a unique phenomenon: public foreclosures. “We know that foreclosure events are sometimes held openly on the steps of the courthouse. So, if we think about the loan officer who works nearby, who sees these foreclosures happening on his way to work or on a lunch break, they might be more likely to feel that things must be really bad financially,” says Xuan. “ Moreso than someone who only hears reports on the news or in conversations at work, we were curious about how experiencing these foreclosure events firsthand might influence individual decision makers.”

Public Exposure

Using the loan-level data they had obtained, Xuan and his team began mapping the locations of the banks in their study. “We measured the distance between those branches and the nearest courthouse,” he says. “From there we started looking at loan rejection rates and how they corresponded to the branch proximity to the county courthouse where foreclosures were held publicly.”

One might think that proximity to the courthouse wouldn’t matter since everyone is exposed to the same kind of news reporting, and most loan officers have the same basic ideas about how the economy is doing, so the salience of these public foreclosure events might not even have a significant impact on their decisions. But what Xuan and his team found was something quite the opposite.

“As soon as we did the first pass on the data, the result was very robust,” Xuan says. “It turns out that mortgage application rejection rates are more sensitive to foreclosure intensity when loan officers are more exposed to foreclosure news—meaning when they are close enough to a courthouse, they are more likely to reject a loan application when foreclosure events are more intensively held outside this courthouse. This is in spite of the same housing market and bank fundamentals across the country.”

Stronger Performance

A secondary result was that loans from those branches that were closer to the courthouses had lower default rates. This is consistent with higher lending standards being applied. “If we compare a loan officer working at a branch next to the courthouse versus another loan officer, working for the same bank, in the same county, at a branch farther away from the courthouse, it seems to be that the only difference here is the level of exposure to the foreclosure news by simply working nearer to the place where foreclosures are being conducted in the public view,” Xuan says.

“We looked at which counties actually hold these foreclosures in public,” he says. “Some of these foreclosures are now online, or indoors, in many counties. In those cases, it wouldn’t have the same impact. But for those counties that do hold foreclosures outside and in public, the effect was there.”

Big Impact

This exposure to public foreclosures on the courthouse steps had a significant impact on the individual loan officers in their study. This exposure makes the loan officers who are nearer the courthouse more risk averse, which makes them more stringent when applying standards to loan applications. “That means they reject more applications than other officers, even though they’re working for the same banks located in the same counties,” Xuan says. “Incidentally, loans that were approved by those loan officers were less likely to default because the loan officers were less lenient. That was the big punch line.”

During times of economic hardship, economists often talk about how banking fundamentals can hurt the credit supply, but as Xuan’s research shows, there’s an unspoken individual level of bias to consider as well. “The impact of adverse shocks on bank fundamentals and economic consequences has been studied a lot. But focusing on this micro level allows us to see how individual risk beliefs and preferences are impacted by their exposure to adverse market events, ultimately influencing decision making. That’s something new for us to consider,” he says.

Adverse Effects Beyond the Local

Another key finding in their study is something akin to a self-fulfilling prophecy at the individual level in the banking industry. “Our finding suggests a self-perpetuating mechanism of sentiment which operates prominently during seasons of economic downturn and can exacerbate credit contraction and prolong the economic recovery,” Xuan says.

“What I mean by that is, when things are bad, and when those individual decision makers are exposed more to that bad news, they operate more cautiously. They may want the economy to recover, but it may take longer because they are being more stringent and cutting back the credit supply even more,” Xuan says.

“For example, one of the tests we did was to measure credit supply by bank branches that were closer to courthouses, and we found that they had lower supply than branches of the same bank in the same county that were farther away from the courthouse. Our argument is that there is an effect on lending decision makers that could prolong a credit crunch and delay economic recovery.”

Major Implications

The main takeaway, according to Xuan, is that there is a strong link between the risk-taking behaviors of lending decision makers and their exposure to events of public foreclosures. “This individual bias could actually result in real outcomes and have real implications for performance, credit supply and the economic recovery,” Xuan says. “We all know that everyone is biased but the question to ask is, do we see any real impact on the economy? The answer here is yes, we do see substantial implications. That’s very important.”

“Knowing this, it might help to let loan officers know how their individual perceptions are impacting their decisions,” Xuan says. “If everyone could be exposed to the same level of news regarding the economy and perhaps through additional training, this effect might be reduced in the future.”