"During the housing boom, banks were a lot less likely to request an audited financial statement from developers, builders, and others in the industry," Sutherland said. "That meant banks had a lot less information about how likely it was the firm was going to be able to repay the loan."
In the new study, Sutherland and colleagues Petro Lisowsky of the University of Illinois and Michael Minnis of the University of Chicago found that construction firms that were not required to provide audited statements, as well as the banks that lent to them, were less likely to survive the financial crisis. Failures were most common in the Southeast and West—the two areas of the United States with the greatest housing price growth before the crisis.
After the housing market collapsed, banks tightened their standards for commercial construction loans, according to the researchers. "When times are good, banks have a tendency to reduce their standards, and keep expanding their loan portfolio with the expectation that they are going to be repaid," Sutherland said.
The researchers obtained exclusive financial data on borrowers and lenders from the banking industry's Risk Management Association. The researchers compared lending standards banks used for construction industry firms with the standards applied to firms in other industries. During the housing boom, banks relaxed standards significantly more for construction firms, the researchers found.
The research is detailed in the working paper, Economic Growth and Financial Statement Verification: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2502889
The construction industry played key roles in both the economic boom that preceded the financial crisis and the great recession that followed. In 2006, construction accounted for 6.7% of total U.S. employment, just behind health care and professional services, according to the Bureau of Economic Analysis.
After the crisis, construction employment fell by one-fourth. The industry lost 2.1 million jobs, which represented 36 percent of net employment lost in the United States in the recession.
Failure to demand audits from construction firms exposed banks to fraud, according to Sutherland.
"Sometime firms would double collateralize loans—pledging the same land to two different lenders—other times the land didn't exist or the firm didn't own it," Sutherland said. "In other cases, documentation was provided that was later discovered to be fraudulent. Audits could have detected many of these deceptions."
The major reforms instituted since the financial crisis have not addressed the problem of lax lending during the expansion phase of the business cycle, according to Sutherland.
"Although we have emerged from the crisis, regulators need to remain cognizant of how lending standards vary over an industry's economic cycle," he said. "When times are good, banks often cut their lending standards, and we can see the consequences. Many banks in our study either failed or required massive capital injections."
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SOURCE MIT Sloan School of Management