Systemic Risk and Market Institutions

Yale Journal on Regulation, Dec 2009

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

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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)


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Andrey D. Pavlov, Susan M. Wachter. Systemic Risk and Market Institutions, Yale Journal on Regulation, 2009, Volume 26, Issue 2,