Bank Municipal Bond Holdings and Mortgage Lending Standards

We provide evidence that the geographical segmentation of the municipal bond market — induced by state tax exemptions — leads banks to diversify their mortgage lending across states. Municipal bond holdings expose banks to local real-estate risk: these securities are largely backed by property-tax revenues with high elasticity to house prices. Consistent with a diversification motive, the effect is stronger for banks with weaker balance sheets, for those whose mortgage lending is highly concentrated in their home state, and towards areas whose housing markets are less correlated with those of the home state. Interestingly, this out-of-state expansion is accompanied by a relaxation of lending standards, as banks approve mortgages with lower FICO scores and higher debt-to-income ratios, which subsequently results in more non-performing loans. The relaxation of lending standards emerges in states where banks lack branch presence and in highly competitive markets, where expanding requires attracting borrowers through looser screening. Diversification thus may generate risk-taking as a by-product.