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Systemic Risk through Securitization: The Result of Deregulation and Regulatory Failure

49 Pages Posted: 26 Mar 2009 Last revised: 16 May 2012

Patricia A. McCoy

Boston College Law School

Andrey D. Pavlov

Simon Fraser University (SFU) - Finance Area

Susan M. Wachter

University of Pennsylvania - Wharton School, Department of Real Estate ; University of Pennsylvania - Accounting Department

Date Written: February 9, 2009

Abstract

Without regulation, securitization allowed mortgage industry actors to gain fees and to put off risks. During the housing boom, the ability to pass off risk allowed lenders and securitizers to compete for market share by lowering their lending standards, which activated more borrowing. Lenders who did not join in the easing of lending standards were crowded out of the market. Artificially low risk premia caused the asset price of houses to go up, leading to an asset bubble and breeding fraud. The consequences of lax lending were thereby covered up.

The market might have corrected this problem if investors had been able to express their negative views by short selling mortgage-backed securities, thereby allowing fundamental market value to be achieved. However, the one instrument that could have been used to short sell mortgage-backed securities - the credit default swap - was also infected with underpricing due to lack of minimum capital requirements and regulation to facilitate transparent pricing. As a result, there was no opportunity for short selling in the private-label securitization market. The authors propose countercyclical regulation to prevent a race to the bottom at the height of the business cycle.

Keywords: Securitization, credit default swap, subprime, mortgage, asset bubble

JEL Classification: D21, D43, G12, G18, G21, G28, K20, L13, L51

Suggested Citation

McCoy, Patricia A. and Pavlov, Andrey D. and Wachter, Susan M., Systemic Risk through Securitization: The Result of Deregulation and Regulatory Failure (February 9, 2009). Connecticut Law Review, Vol. 41, p. 493, May 2009. Available at SSRN: https://ssrn.com/abstract=1367973

Patricia Ann McCoy (Contact Author)

Boston College Law School ( email )

885 Centre Street
Newton, MA 02459-1163
United States

Andrey D. Pavlov

Simon Fraser University (SFU) - Finance Area ( email )

Burnaby, British Columbia V5A 1S6
Canada
604 291 5835 (Phone)
604 291 4920 (Fax)

Susan M. Wachter

University of Pennsylvania - Wharton School, Department of Real Estate ( email )

The Wharton School
3620 Locust Walk
Philadelphia, PA 19104-6330
United States
215-898-6355 (Phone)

HOME PAGE: http://real.wharton.upenn.edu/~wachter/index.html

University of Pennsylvania - Accounting Department ( email )

3641 Locust Walk
Philadelphia, PA 19104-6365
United States

HOME PAGE: http://real.wharton.upenn.edu/~wachter/index.html

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