From Construction Today
Lax mortgage lending by banks has long been recognized as a major cause of the financial crisis. But banks played another, lesser-known role in the crisis. In much the same way that banks failed to verify the creditworthiness of people buying homes, banks also neglected to verify financial qualifications of those building homes — developers, contractors and other firms in the construction industry.
I, along with fellow researchers Petro Lisowsky of the University of Illinois and Michael Minnis of the University of Chicago, discovered this phenomenon by examining previously unreleased banking industry data on borrowers and lenders from 2002 to 2011 — a span that includes the years before, during, and after the financial crisis. We compared the lending standards banks used for firms in the construction industry with the standards banks applied to firms in other industries.
We found that during the housing boom, banks relaxed standards more for construction firms and were less likely to request audited financial statements. Without audits, financial institutions lacked vital information as to whether firms could repay loans. Banks also opened themselves to fraud. Developers could double collateralize loans — pledging the same property to two different lenders — or they could use as collateral land they didn’t even own.
Andrew Sutherland is Assistant Professor of accounting at the MIT Sloan School of Management.