Bank failures, capital buffers, and exposure to the housing market bubble

Abstract

We develop housing overvaluation measures that are separate from local economic conditions and show that banks with greater exposure to such overvalued markets have higher mortgage delinquency and charge‐off rates and significantly higher probabilities of failure during the 2007–2009 financial crisis even after controlling for bank characteristics. While high house prices relative to fundamentals present a greater likelihood of house price correction, we find no evidence that banks managed this risk by building capital. We also show that our overvaluation measures are important in explaining individual mortgage loan defaults and could be used to improve bank risk management.