Loose Lending In The Construction Industry

Sutherland MIT Sloan graphic 2

Figure 1: Acquisition, Development, and Construction Loan Growth, Bank Failures, and Deposit Insurance Fund Losses by Region. (Source: United States Office of Inspector General 2012, pg. 6).

By Andrew Sutherland

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. Sutherland MIT Sloan graphic 1

Figure 2: Acquisition, Development, and Construction (ADC) Loans at FDIC-Supervised Institutions, 1991 to 2010. This figure reports the amount ($ billions) of ADC loans outstanding each year. (Source: United States Office of Inspector General 2012, pg. 4)

Audits could have picked up these deceptions.

We also found that the construction firms that were not required to provide audited statements, as well as the banks that lent to them, incurred significant losses and were less likely to survive the financial crisis. Failures were most common in the Southeast and West — the two areas of the United States that had seen the biggest increases in house prices before the crisis.

These lending practices, which led to the collapse of the construction industry, were disastrous for the U.S. economy. In 2006, construction accounted for 6.7 percent of total U.S. employment, just behind healthcare and professional services. After the crisis, the construction industry lost 2.1 million jobs, or 36 percent of net employment loss in the United States in the recession.

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Figure 3: Macroeconomic and Financial Statement Trends for the Construction Industry. This figure presents four data series for the construction industry over the years 2002 to 2011: Gross Domestic Product (GDP); Employment; % Unqualified (the proportion of financial reports that were audited for construction firms relative to non-construction firms); and % Tax/Other (the proportion of financial reports that were tax returns or other financial statements for construction firms relative to non-construction firms). The financial report data was collected from the RMA’s Annual Statement Studies. All data series are scaled relative to the base value in 2002.

The behavior of banks after the crisis is also noteworthy: they tightened their standards and became much more likely to require audited financial statements from construction firms seeking loans. However, the reversal came too late, as loans that shouldn’t have been made during the boom soured, and many banks in our study failed or required significant capital injections.

Given that construction lending booms have preceded several severe banking crises, borrowers and regulators should monitor lending standards as this segment of the economy recovers.

Andrew Sutherland is assistant professor of accounting at the MIT Sloan School of Management. He may be reached at AGS1@mit.edu.  

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