Systemic Risk and Market Institutions
Vol.
Systemic Risk and Market Institutions
Andrey D. Pavlov 0 1
Susan M. Wachter 0 1
0 Thi s Article is brought to you for free and open access by Yale Law School Legal Scholarship Repository. It has been accepted for inclusion in Yale Journal on Regulation by an authorized administrator of Yale Law School Legal Scholarship Repository. For more information , please contact
1 Andrey D. Pavlov & Susan M. Wachter, Systemic Risk and Market Institutions , 26 Yale J. on Reg. (2009). Available at:
-
Andrey D. Pavlov t
Susan M. Wachtert t
Systemic Risk and Market Institutions
With private-label mortgage-backed securities (MBS), investors bore
default risk. This risk should have been priced. As systemic risk grew, why
didn't the pricing of risk increase? We point to market institutions' incentive
misalignments that cause asset prices to rise above fundamentals, producing
systemic risk. The model attributes the assetprice inflation to the provision of
underpricedcredit as lending institutions misprice risk to gain market share.
The resulting asset price inflation itself then generatesfurther expansion of
underpricedcredit.
Introduction
Today's financial crisis is the result of market institutions' "rules of the
game" that produce systemic risk. In efficient markets, asset prices follow a
random walk. We point to market institutions' incentive misalignments that
cause asset prices to rise above fundamentals, producing systemic risk. We first
describe the pro-cyclical expansion of underpriced credit in the United States
that drove asset prices up. We then briefly present the basics of a model that
explains that this outcome is inevitable, given incentives to take risk to gain
short-term profits. The model attributes the asset price inflation to the provision
of underpriced credit as lending institutions misprice risk to gain market share.
The resulting asset price inflation itself then generates further expansion of
underpriced credit. We conclude with a discussion of why markets fail to
contain inflated asset prices through the short-selling of assets or indices of
assets and offer implications for market institutions going forward.
I. The Recent Deterioration of Lending Standards
The U.S. residential mortgage and housing markets are at the center of the
worldwide credit bubble and the subsequent financial crisis. The volatility
adjusted run-up in U.S. housing prices, particularly after 2003, exceeded price
t Associate Professor of Finance, Simon Fraser University, Vancouver, Canada.
tt Richard B. Worley Professor of Financial Management and Professor of Real Estate, Finance and
City and Regional Planning, Wharton School of the University of Pennsylvania.
increases among all the major trading partners of the United States. Similarly,
the recent volatility-adjusted price decline is also more severe in the United
States than in its major trading partners.' The price and price-rent ratios that
were increasing in the United States before 2003 were attributable to interest
rate declines and income increases, but not so after 2003. The U.S. house price
run-up post-2003 was accompanied by a credit bubble as subprime and other
nontraditional mortgage lending took off in 2003. These loans differed from
previously prevalent securitized agency debt in their lower lending standards,
which, in turn, permitted constrained borrowers to overcome credit barriers and
increased the demand for homes.
As the amount of nonprime lending increased both absolutely and as a
share of overall lending, the price of risk imbedded in these loans, rather than
increasing as might have been expected, decreased, both relatively and
absolutely. For example, many of these loans were "teaser-rate" adjustable rate
mortgages (ARMs) 2 and as such were priced off of LIBOR. 3 Over time, the
margin over LIBOR decreased, despite the fact that as marginal borrowers
became homeowners, the average borrower became riskier.
As the demand for homes increased, with the marginal borrower now able
to overcome credit barriers, prices increased. Default rates, driven by
loan-tovalue ratios, thus remained low. With rising home prices it might have seemed
reasonable that with the resetting of teaser-rate loans and recasting of option
ARMs, 4 it would not be a problem to refinance, since home prices would rise
and exceed debt levels.
Each nonrecourse mortgage loan contains an imbedded put option that
allows the borrower to "put" the property to the lender for the outstanding
balance of the loan by defaulting on the loan. In other words, the borrower
owns a put option that he can exercise against the lender to effectively sell the
I For a discussion of why this occurred in 2003 and the role of fundamentals in the pricing of
homes prior to 2003 but not after, see Andrey D. Pavlov, Zoltan Poznar & Susan M. Wachter, Subprime
Lending andReal Estate Markets (Univ. of Pa. Law School Inst. for Law & Econ., Working Paper No.
08-35, 2008), available at http://ssrn.com/abstr (...truncated)