A previous version of this working paper was originally published in January 2022.
Lax financial regulation encourages some banks to issue risky residential mortgages. In the event of an adverse aggregate housing shock, these banks fail. When banks do not fully internalize the losses from such failures (due to limited liability), they offer mortgages at less than actuarially fair interest rates. This opens the door to homeownership for young, low net-worth individuals. In turn, the additional demand from these new home-buyers drives up house prices. This leads to a non-trivial distribution of gains and losses from lax regulation among households. On the one hand, renters and individuals with large non-housing wealth suffer from the fragility of the banking system. On the other hand, some young middle-wealth households are able to get a mortgage and buy a house, and current (old) homeowners benefit from the increase in the price of their houses. When these latter two groups, who benefit from the lax regulation, constitute a majority of the voting population, then regulatory failure can be an outcome of the democratic political process. We find empirical support for this mechanism in the voting patterns in U.S. Congress, where members from districts with higher homeownership rates or lower income inequality (larger middle class) tended to vote for lax mortgage regulation prior to the Great Financial Crisis.
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