Safe bonds, risky mortgages: Municipal bonds influence banks' lending practices
Certain tax incentives encourage banks to invest in municipal bonds. The unintended effect is that they loosen their mortgage lending standards in other markets, increasing financial fragility.
Imagine you’re a banker in the United States deciding where to invest. Your home state offers a great incentive: municipal bonds with attractive tax exemptions. Naturally, you'd want to load up on these bonds. But what if holding too many of these bonds actually changes your mortgage lending decisions? Our recent research shows that banks facing precisely this scenario respond by relaxing their lending standards, but interestingly, they do it away from home.
In a recent study conducted with my colleague Vahid Saadi from the University of Liverpool, we uncovered how municipal bonds, despite being traditionally seen as safe and conservative assets, can drive banks towards riskier mortgage practices outside their home states.
Municipal bonds are appealing because of tax exemptions offered at state and federal levels, making them a staple investment for many banks. But these bonds are mostly local—banks typically hold municipal bonds issued within their home state. The downside? This creates concentrated exposure to local risks, especially real estate markets, as municipalities heavily rely on property taxes that fluctuate significantly with house prices.
The other side of risk diversification
Our research, using comprehensive data from US banks and mortgage applications between 2002 and 2017, demonstrates a surprising consequence of these investments. Banks that heavily invest in municipal bonds are exposed to the local real estate market's ups and downs. To manage this risk, they attempt to diversify—but not by reducing bond holdings. Instead, they loosen mortgage lending standards in regions far from home to expand their geographical exposure.
By loosening their mortgage lending standards, these banks increase financial fragility in distant markets
Specifically, these banks approve riskier loans—loans with lower borrower credit scores (FICO scores), higher loan-to-value ratios, and higher interest rates—in states where they have less market presence. Why riskier loans? Banks entering unfamiliar territories face stiff competition from local lenders who possess better market knowledge. To compete, banks must become less selective, accepting borrowers whom local lenders have rejected.
This strategy helps banks geographically diversify their real estate risks. However, it's a problematic approach. By extending mortgages to riskier borrowers, these banks inadvertently increase financial fragility in distant markets. Local banks and communities end up absorbing these negative externalities, potentially exacerbating financial instability.
The unintended effects of tax policies
To firmly establish these findings, we exploited an exogenous event: Moody’s recalibration of municipal bond ratings in 2010. This event, unrelated to any changes in municipalities’ actual financial health, provided a unique natural experiment. Post-recalibration, upgraded municipal bonds saw price increases. Banks holding many of these upgraded bonds reduced their exposure to municipal bonds due to higher market values. Consequently, these banks significantly lowered their previously lenient mortgage approval rates outside their home states. This shift strongly indicates that the initial risky lending was indeed driven by banks’ need to diversify away from their home-state municipal bond risks.
Our findings highlight a hidden consequence of a seemingly beneficial tax policy: the tax exemptions intended to support local governments inadvertently encourage banks to adopt riskier lending behaviors elsewhere. This is a critical insight for policymakers, regulators, and stakeholders in both banking and real estate markets.
Some tax incentives encourage banks to excessively concentrate in local municipal bonds
States with higher corporate income taxes amplify these distortions because they incentivize even more municipal bond holdings, further embedding these risky lending practices into banking operations. Our research also discovered variations based on how states support financially distressed municipalities. Banks headquartered in states offering significant support to troubled municipalities felt less compelled to diversify geographically, indicating that robust state policies can mitigate the unintended consequences we document.
Moreover, banks with weaker financial health—measured by lower capital ratios and higher non-performing loan ratios—were especially aggressive in relaxing standards in distant markets. This amplifies systemic risks, as financially vulnerable institutions are more likely to propagate instability across regions.
Reconsidering tax incentives
What can policymakers do? Our research suggests reconsidering the tax incentives that encourage banks to excessively concentrate in local municipal bonds. Enhancing transparency and providing guidelines for prudent diversification could help banks manage local risks more sustainably.
In conclusion, seemingly safe municipal bond investments can inadvertently drive banks to risky mortgage lending practices far from home, posing broader financial stability concerns. Addressing this paradox requires thoughtful policy adjustments to maintain the benefits of municipal bonds without inducing unwanted systemic risks.